The long and turbulent road to financial stability in the eurozone

In order to fully understand the difference between the ESM and the other previously established European stability mechanisms and funds, and how it represents a new, more robust firewall than its predecessors, it seems important to understand the reasons why the ESMF and EFSF were created, and what contributions they may have made and difficulties they may have encountered.

The Eurozone crisis, more commonly known as the « debt crisis », began in January 2010 with the outbreak of the Greek crisis, and then spread to the entire zone. European countries, already hard hit by the financial crisis of 2007-2009 and the scarcity of liquidity, quickly found themselves in difficulty. To finance their policies, they were forced to increase their deficits and borrow on the markets, at ever-higher rates due to rising risk premiums on sovereign debt. As a result, the burden of debt has increased, governments are finding it difficult to repay their debts, and are finding it hard to borrow again. This has led to a negative spiral, with a reduction in the average maturity of sovereign debt bonds.

Given that the vast majority of these countries’ debt is issued in euros, and that the markets remain highly skeptical about the ability of certain countries to repay it, speculation on sovereign securities issued in euros is tantamount to speculation against the single currency, with investors switching to the dollar. At the same time, the euro appreciates against an undervalued dollar (making its products more attractive). The entire Eurozone is therefore at risk, and the risk of contagion from one country to another remains high. To stem the spread of the crisis, the European Union (EU) has introduced measures to provide financial aid to countries in difficulty. The European Financial Stability Facility (EFSF) and the European Mechanism for Financial Stability (EMFSF) were created for this purpose in May 2010 and January 2011 respectively.

The EFSM is endowed with 60 billion euros, and its operating mode is fairly straightforward: the EU borrows on the capital markets, via the EFSF, from financial institutions in order to support the States, which in turn undertake to meet certain conditions[1]. Ireland and Portugal are two examples of countries that have used the ESMF since 2010. This mechanism is simply a complement to the EFSF, set up a few months earlier to deal with the scale of the crisis. It is an intergovernmental mechanism with a capacity of 440 billion euros, which was intended to ensure the financial stability of countries, while implementing a massive plan totaling 197.5 billion euros in aid to Greece (in partnership with the IMF to the tune of a further 39.93 billion euros) spread over time with several payment tranches. EFSF assistance was also provided to Ireland and Portugal, and more recently to Spain in 2012.

The EFSF: conditions for stability…

The EFSF is a public limited company in which the countries of the eurozone are shareholders. It raises its financing on the markets (by issuing securities), with the guarantee of the participating countries. The latter contribute according to their share in the capital of the European Central Bank (ECB), increased by 20%, to ensure a principle of over-guarantee (in case it is necessary to compensate for the non-participation of a possible beneficiary state): Germany and France representing 47.53% of the total, Italy 17.91% and Spain 11.9%. The EFSF lends funds, but has pari passu status , meaning that it will be treated in the same way as other investors in the event of a restructuring[2] of the debt of a country under the program.

In addition to these loans, countries may have access to precautionary programs. The aim of these programs is to provide credit lines, while preventing potential crisis situations in these countries. At the same time, the EFSF protects its structure ex ante, by preventing any of its contributors from finding themselves in major difficulty.Three types of credit line exist: the Precautionary Conditioned Credit Line (PCCL), for countries with sound economic fundamentals (debt deemed sustainable, compliance with the Stability and Growth Pact, unlimited access to the primary market); the Enhanced Conditions Credit Line (ECCL)for vulnerable countries with intermediate-quality fundamentals that need to implement corrective policies to strengthen themselves; and the Enhanced Conditions Credit Line With Sovereign Partial Risk Protection (ECCL+), whose criteria are similar to those of the ECCL, but which is used more to protect a country against the risk of default on its sovereign debt.[3] These lines can amount to between 2% and 10% of the beneficiary country’s GDP, and their duration is one year, renewable twice by six months.

The EFSF’s structure has gradually evolved to take better account of the Eurozone’s economic situation and to meet countries’ expectations. This is why, as of July 21, 2011, its expanded role also included: financing the recapitalization of financial institutions via loans to governments and intervening on the debt market (primary and secondary) to purchase sovereign securities, its purchases not to exceed 50% of the total amount issued.

… but limited in the end

To make this extension possible, it seemed necessary to increase the fund’s financing capacity. Reaching a capacity of 1,000 billion euros was recommended to ensure the stability of the zone (i.e., to be able to provide aid to countries such as Spain or Italy in case of need) and to hope to absorb any negative shocks. Three types of tool were devised to achieve this: the use of leverage, Collateralized Debt Obligations (CDOs) (which is paradoxical, given that they were at the root of the crisis and helped to widen spreads…) or a Co-Investment Fund, which would combine public and private funds to finance governments and banks.

However, even with the introduction of such tools in July 2012, the 1,000 billion target seems unattainable. What’s more, when it was initially set up, the EFSF was rated triple-A by the rating agencies, but this rating was maintained only if the fund was backed by guarantees from the contributing countries, themselves triple-A rated. Consequently, as soon as a country’s rating is downgraded, the EFSF’s lending capacity is automatically reduced in proportion to that country’s share of the total contribution, as the capital it contributes to the fund can no longer be considered as sufficiently secure guarantees. The downgrading of France’s credit rating has consequently affected the EFSF’s lending capacity. In the final analysis, only 58% of guarantees now benefit from a triple-A rating, which is far from sufficient. As a result, the EFSF’s lending capacity now stands at just 148 billion euros (440 initially minus almost 292 in aid plans). So, if ever a country as large as Italy needed to call on the European stability mechanisms, neither the EFSF nor the ESMF could guarantee assistance.

The inadequacy of its lending capacity, and its over-dependence on variations in the ratings of its member countries, have underlined the limits of the EFSF, as well as the ESMF, in restoring a degree of European stability, let alone ensuring it in the years to come. Despite the sums provided to countries in difficulty, the improvements they have recorded and the signal these mechanisms send to the market to show that a degree of European solidarity exists in the Eurozone to maintain and support its members, the fact remains that stability remains very limited. These two mechanisms should continue and complete their missions until mid-2013, while the ESM should now take over. It seems to be more robust and more comprehensive in helping countries to finance themselves more cheaply on the financial markets, while at the same time trying to reassure them, where the MESF/FESF pairing failed somewhat, given the widening spreads of certain countries and the persistent skepticism towards them.

The ESM, bigger and stronger

The ESM recently came into operation last October, and in principle should gradually lead the Eurozone towards greater stability and sustainability. It does not have the same status as the two previous mechanisms (which were limited companies), as it is an international financial institution. It has a capital of 700 billion euros, comprising callable capital (which acts as a guarantee) of 620 billion euros and paid-up capital of 80 billion euros (11.4% of the total). Its maximum lending capacity is initially set at 500 billion euros (i.e. a leverage target of 500/700 = 71.4% to be maintained whatever happens).

This paid-in capital is immediately available to the ESM, which must maintain a ratio of 15% between paid-in capital and outstanding issues (in the case of an aid program). This objective of maintaining the ratio, together with the fact that the ESM will borrow from its own capital, ensures that the ESM maintains its triple-A rating, despite the downgrading of some of its members, which is a major advantage over the EFSF.

The calculation of member contributions is similar to that of the EFSF, with each country contributing a share equivalent to its ECB contribution key. The paid-up capital is to be paid in five equal annual instalments, starting in July 2012. A country like France has chosen to pay two of its installments now, for a total of 6.52 billion euros. The intention was for other countries to do likewise, to speed up the implementation of the ESM. It is very important to note here that all these payments do not affect the public balance (except in the case of additional payments to cover any losses incurred by the ESM) and are considered to be equity investments by the States, but they do reduce the public debt. As for the callable shares – some 126.4 billion in France, 168.3 billion in Germany and 111.1 billion in Italy, to name but a few – they constitute guarantees and are perceived as loans, and therefore cannot be included in the debt.

States with a GDP per capita of less than 75% of the European Union average in the year preceding their accession to the ESM (note: not the Eurozone) will be able to benefit from a temporary correction of their participation for twelve years[4], passed on to the other member countries. But this should not be the case for any of the Eurozone countries, which are well above this average. Even if the trajectory of this ratio for Greece is downward, it still has a small margin before reaching this limit.

The banking sector: expectations remain

The tasks of the ESM do not really differ from those of the EFSF: it must provide financial aid in the form of loans, credit lines (of the same type as those mentioned above) and buy securities issued by a member on the primary market or carry out operations on the secondary market. As the EFSF only deals with the secondary market, the ability to buy directly on the primary market is an important advance for the ESM. Another very important aspect concerns financial assistance to banks. However, we still have to wait for the establishment of a single banking supervisor or European Single Supervisory Mechanism (ESSM, another new acronym, long live Europe), under the control of the ECB. This should happen around January-March 2013.

Unfortunately, negotiations are running behind schedule for a number of reasons: firstly, banking harmonization is taking a long time, with countries like Germany holding up the process by trying to avoid certain restrictions and rules for its regional banks; and secondly, the ESSM will apply not just to the Eurozone, but to the EU as a whole. Countries that do not share the single currency are understandably reluctant to see their banks supervised by the ECB. A country like the UK does not seem to want to follow the ECB’s lead, which is known to be very (too?) rigorous on (« sacrosanct ») price stability and its (hyper)aversion to inflation, all the more so as it has its own independent Central Bank and its own objectives in terms of monetary policy.

It is conceivable that a country like Spain might be slow to request MES assistance, not least because of the slowdown in negotiations. Of course, this is not the only reason, as the regional elections, the decisive steps before deciding on the budget, have not yet taken place (on November 29 in Catalonia), forcing Spain to wait. Moreover, Spain does not want to send out the wrong signal to the market by calling for help, as it hopes to reap the rewards of its numerous structural adjustments (labor market, VAT hikes, return to competitiveness) before sounding the alarm, which the markets could interpret as an intrinsic impotence of its economy. However, despite less disastrous than expected stress test results for its banks (a requirement of almost 60 billion euros, instead of the 100 billion expected), dating from October, the Spanish banking system remains very weakened by the crisis. An intervention by the MES, via the Fondo de Reestructuración Ordenada Bancaria (FROB), to recapitalize the banks seems urgent, if not decisive.

MES and restructuring cases

The treaty establishing the ESM stipulates that it has senior status[5] in relation to other creditors in the event of restructuring (the IMF remains the preferred creditor, even in the face of the ESM). On the other hand, should the ESM be authorized to recover the loans provided by the EFSF (non-senior), the latter will retain their status. For those countries already under the EFSF program, the new loans released by the ESM will continue to benefit from the same regime as before (non-seniority). Since private investors are not considered pari passu vis-à-vis the ESM, securities issued by a country under the ESM program will be less attractive. We could imagine a change in the status of the ESM in this respect, to attract investors, but this would require a modification of the treaty by all its members.

The ESM has taken a number of measures to facilitate any restructuring of a country’s debt, and to prevent it from being disrupted and slowed down by negotiations and the demands of different parties. From January ¹, 2013, the introduction of collective action clauses (CACs) should make it possible to organize, ex ante, such restructurings, concerning securities with a maturity of more than 1 year. A CAC is a group of private creditors representing from 1/3 to ¾ of the total number of sovereign bondholders. Thus created, it leaves the opportunity to negotiate by « crushing » a minority that would go against the restructuring. The guarantee of an effective, organized and successful restructuring should, in principle, reassure investors[6], which would contribute to lowering spreads, vis-à-vis the German Bund, on sovereign debts and thus borrowing costs for states using the ESM and CAC to issue their bonds.

It seems difficult to know whether a switch to CACs would only have positive effects and would indeed reduce borrowing costs for governments. Assuming that a country’s debt can be restructured sends a very negative signal to the market. Indeed, the probability of even a partial default by a government on its debt stock increases, and should discourage investors from buying securities issued by that government. The creation of CACs then becomes virtually synonymous with inevitable restructuring, and spreads on these securities automatically rise. What’s more, it is conceivable that creditors who are members of a CAC, with their increased bargaining power, could thwart the decision to restructure, or even threaten the seniority position of the IMF/ESM.

New problems ahead?

Even if, on the whole, the ESM is a more effective, larger and more robust mechanism than its predecessors, a number of questions remain concerning its evolution and its real capacity to help countries, while enabling them to finance themselves more cheaply on the markets. Even before its creation, a number of economists were advocating that a European Financial Stability Facility should play the role of lender of last resort (LLR), if it really wanted to ensure total and lasting stability. At the time, there was talk of the ESM being granted a banking license by the ECB, so that it could move towards this role of financial and banking intermediary and become a pseudo-lender of last resort.

In the end, this did not happen, and we can expect the ESM to encounter the same difficulties as the EFSF in the near future, should Spain and Italy simultaneously request assistance. The ESM would not be able to issue enough securities for both countries at the same time. What’s more, if this were to happen, it would affect the public finances of France and Germany, which would find themselves as the fund’s main contributors. A widespread panic would ensue, and the ESM’s ability to issue bonds would be severely compromised, with the result that it could make losses. Hence the need for countries to commit to binding budgetary rules (austerity) as soon as possible. However, by imposing such constraints, there is a clear risk of stifling growth (or potential growth) and any hope of recovery. Austerity policies, involving spending cuts and revenue increases, are therefore achieving very mixed results, and despite the many reforms and efforts undertaken, it’s all in vain. Countries are not reassuring the markets and are not necessarily paying lower spreads, as in Spain and Portugal. MES intervention in these countries is likely to be prolonged over time, which is not really the desired objective.

The ESM has one obvious advantage for a country benefiting from its aid: it has to pay lower spreads than in the situation where it is trying to finance itself on the markets, without aid. These lower spreads should attract investors looking for more or less secure assets, which generate some return, while being guaranteed by the security provided by the ESM. This search for yield at lower risk could make securities issued by countries not using the ESM program less attractive. Despite healthier economic fundamentals, a country outside the program could find itself in difficulty in issuing its own securities, due to this arbitrage by investors.

Is the OMT the ideal complement to the ESM?

The introduction of Outright Monetary Transactions (OMT) by the ECB could be the ideal complement to the ESM, resolving a number of issues. Since the ESM cannot be a PDR, and certainly does not have enough funds to simultaneously help countries such as Spain and Italy, the ECB’s unlimited purchase of sovereign bonds on the secondary market within the framework of the OMT would appear to be the missing link for financial stability in the Eurozone.

To benefit from the OMT program, a country must first be under an EFSF/ESM program, or have recourse to a precautionary program such as ECCL or PCCL. The ECB has pari passu status, which marks a major change compared with the former Securities MarketProgram (SMP). The two mechanisms are therefore closely linked. However, the OMT is not so open-ended, as it only concerns short-maturity sovereign bonds, up to three years. This is an initial form of support for the stability mechanism, but any difficulties encountered by the ESM will be more likely to concern issues of securities with longer maturities. Moreover, as Mario Dragui announced on October 4:  » OMTs do not apply to countries […] as long as full market access has not been opened up, and this is because OMTs are not a substitute for a lack of access to the primary market »; a country like Portugal cannot therefore have access to the OMT, given that it is unable to issue on the primary market at long maturities.

The ESM and the OMT will therefore work together to maximize the effectiveness of their interventions on both the primary and secondary markets. Although Europe is certainly in a critical state, countries such as the United States and Japan are not necessarily better off, with certain deep-seated structural problems, despite the absence of such strong diversity as in the Eurozone. It is to be hoped, therefore, that all these measures and provisions will support the Eurozone countries and send a strong message to the market, that of a certain European cohesion and solidarity, essential elements in ensuring the Eurozone’s future stability and durability.

Notes:

[1] Treaty on the Functioning of the European Union(TFEU), article 122, paragraph 2: Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned.