What is the European Stability Mechanism (ESM)?
After the June 28-29 EU summit ended, euro area leaders plan to tap the EFSF and ESM to deal with short-term banking/debt and liquidity problems. Let’s take a closer examination of these funds.
The ESM is a permanent rescue funding program which is expected to come online in July 2012, about a year ahead envisioned during the facilities inception in 2010. It has a lending capacity of €500 bn.
It will take over the duties and future bailouts currently being undertaken by the European Financial Stability Facility, or EFSF, which is the temporary rescue funding program set up by the Europeans. It’s lending capacity is €440 bn, of which about €177 bn is being used in the bailout packages of Greece, Ireland and Portugal.
How Does the ESM Work?
The paid-in capital of the ESM may be around €80 bn with another €620 bn in guarantees of callable capital. By being over-funded in can continue to carry a AAA rating when its auctions its bonds in the private market.
From Wikipedia: “According to this treaty, the European Stability Mechanism will be an intergovernmental organisation under public international law and will be located in Luxembourg. It would be open to other members to join and would be led by a Board of Governors. Each state would appoint a governor and the board would either be chaired by the President of the Euro Group or by a separate elected chair from amongst the governors themselves.
Some critics the ESM severely confines the economic sovereignty of its member states and that it provides extensive powers and immunity to the board of ESM Governors without parliamentary influence or control”
Here’s an interesting video, describing the reach of the ESM, and how it skirts sovereignty and therefore is disliked by those that do not favor closer federalism of Europe.
Just a warnings that this video uses dramatic effects to portray the ESM in a negative light, so its important to research this further on your own as this article is meant to be an overview and will not get into these topics of sovereignty.
Still this video is pretty informational because it lays out how the ESM will function.
European Financial Stability Facility Used to Bailout Ireland, Portugal, and now Greece:
When the EFSF was created, the euro zone countries pledged €440 bn euros in loan guarantees for the facility. Nearly half of those guarantees came from Germany and France.
Greece with a debt load of €340 bn was frozen out of the debt markets, and needed other countries to provide a bailout of €110 bn euro (not via the EFSF and not the ESM because its not operational yet).
The EFSF provided part of the funding to bailouts to Ireland and Portugal after these countries were shut out of private capital markets because of the rise in yields in 2011.
The facility lent €44 bn of its its funds to Portugal and Ireland, which faced ruinously high interest rates when rolling over their government debt.
The EFSF has now has footed the bill for most of the second Greek bailout package, which comes to €130 bn, leaving the EFSF with €266 bn left in the piggy bank.
Merkozy Move Up the ESM Timetable:
In December 2011, Angela Merkel, the chancellor of Germany, and Nicolas Sarkozy, the French president, the central players in the response to the crisis, had also agreed to have the European Stability Mechanism take over from the stability facility in 2012, rather than 2013 as originally planned. That decision was ratified by a summit of European leaders on Dec. 9.
Combining the Firepower of the ESM and EFSF:
The debate in Europe now is to combing the €500 bn of lending capacity in the ESM with the remaining €266 bn in the EFSF to bring the total firepower to €766 bn at the Europeans disposal, and hopefully lure the IMF countries to pony up more of their own funds to reinforce the money that the IMF can contribute to stemming any spread of contagion to Spain and Italy.
EFSF Helps Recapitalize the ECB:
The EFSF is also being used to recapitalize the ECB. The EFSF will be a passive participant in the Greek debt restructuring negotiations. The ECB is doing a 100% swap with EFSF bonds, not taking any losses.
WSJ: The idea is for the ECB, in effect, to exchange the Greek bonds it holds for bonds of the European Financial Stability Facility, the euro zone’s temporary bailout fund. The ECB will hold the highly rated EFSF bonds on its balance sheet in place of the Greek bonds it bought as part of its Securities Market Program.
This exchange wont take place until the deal with the Greek bond holders is finalized. The bond swaps as part of the Greek debt restructuring is happening right now, with a deadline for private bondholders to exchange their Greek holdings for at a 53.5% loss.
Monitoring the EFSF Yield vs France and Germany:
The EFSF and the ESM will be auctioning off debt/bonds “backed” by the whole of Europe, providing a “safe” asset which still takes advantage of Europeans borrowing together as opposed to a troubled single country that is frozen out of markets.
However those EFSF and eventually ESM bonds trade in the open market and we want to monitor how “safe” the market believes those funds are. We can do that by measuring the yield of the EFSF bonds in comparison to Germany and France, the main guarantees of the funds.
Here is a sophisticated way to follow the EFSF bond spread, by looking at a 10-year EFSF bond yield and compare it to a German 10-year yield (orange). At the same time we compare the French 10-year yield to the German 10-year (in blue).
What we see is that during the latter parts of 2011, during the acute phase of the most recent flare up in the European sovereign debt crisis both French and EFSF bond yields rose in comparison to to German yields.
This meant that the market’s perception of the EFSF bonds tracks very closely with the bond market’s perception of French bonds, and if more countries get downgraded it will increase the borrowing costs for the European bailout mechanisms.
You can follow these spreads yourself by following this link (they update it everyday): http://fingfx.thomsonreuters.com/2011/10/21/122912fa44.htm
In January 2012, the credit rating of the EFSF was downgraded to AA+ from AAA by Standard & Poor’s, in a reflection of the weakened condition of the nations backing the fund. This will be an important theme as European countries face further downgrades.
Nick Nasad is a macro economist, market analyst, and educator; and one of the main contributors to FXTimes – provider of Forex News, Analysis, Education, Videos, Charts, and other trading resources.
Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.