Monetary union among economically and culturally heterogeneous countries, each with distinct fiscal policy at the national level, is the origin of Europe’s problem. It’s the origin of today’s trade and competitiveness imbalances, debt overhangs and consequently a plethora of policy initiatives – among them, the European Stability Mechanism (ESM), which is designed to provide eurozone member states with financial assistance subject to conditionality. Thus far, most of these initiatives have dealt only with symptoms of the patient rather than diagnosing and treating the disease: This is no way to find a cure. While the ESM takes a critical step forward by severing the link between illiquid banks and their weak sovereigns, it too treats symptoms rather than the cause.
Two possible destinations for the eurozone’s journey could conceivably resolve the current problem by addressing its single root cause: either downsizing to a smaller and more homogeneous group of countries where centralized monetary policy and decentralized fiscal policy stand a chance of working, or evolving to full political and fiscal union with cross-border transfers and deposit insurance. Both choices involve high economic costs with difficult-to-quantify benefits. And ultimately, just like the formation of the Economic and Monetary Union (EMU) in 1999, these are political decisions that would be extremely challenging to implement.
The ESM is a milestone along the journey to the destination of political and fiscal union that European leaders may commit to implement at the Heads of State Summit on 13-14 December this year. At that key meeting, the four presidents – Mario Draghi of the European Central Bank (ECB), José Manuel Barroso of the European Commission, Jean-Claude Juncker of the Eurogroup and Herman Van Rompuy of the European Council – will present their roadmap for the eurozone’s future. Without a considerable degree of commitment to integration in this report and leaders’ endorsement of it, the eurozone likely will remain on a journey to an unspecified destination, and the uncertainty generated could deprive it of the much-needed capital currently flowing out of southern Europe.
Saviour?The ESM by itself is not a saviour that is going to solve the eurozone’s root problem, but it could play a constructive role in the process. But will it? A closer look at the ESM suggests it faces considerable headwinds to achieve what it is set up to do, especially in the absence of eurozone leaders’ lack of commitment to realize political and fiscal union. The program’s limited size, doubts about demand for its bonds, the potential for it to crowd out demand for other European government bonds and concerns about democratic legitimacy all suggest it may fall short of fulfilling its mandate.
The ESM will have a lending capacity of €500 billion. While large, that sum pales relative to the annual borrowing requirements of the Spanish and Italian central governments, whose high bond yields suggest they are at risk of losing market access. Add on other countries that may need more official sector financing – a third round for Greece, a second for Portugal, a first for Cyprus or Slovenia – and the fund’s resources could be exhausted quickly. The ESM would not be able to fund these countries for much more than one year if they all were to lose market access. More resources would be needed for a full three-year program for Spain and Italy, whose combined needs are simply too great for the ESM to handle.
Even if the ESM were to receive more resources, it is not clear that it will be able to issue as many bonds as its lending capacity permits at a reasonable yield. Its predecessor, the European Financial Stability Facility (EFSF), has had some difficulties finding investors to buy its bonds. The EFSF has €131 billion face value of bonds outstanding as of 29 August 2012. Of this amount, the EFSF placed €46 billion in the primary market with investors. The ECB, however, was the ultimate source of funds for the remaining €85 billion: The EFSF gave its bonds to the Greek and Spanish governments in return for IOUs; the governments in turn gave them to Greek and Spanish banks in return for equity stakes or IOUs; and the banks then used them as collateral to borrow money from the ECB. Thus the ECB, not investors, became the ultimate source of funds for the EFSF. If the ECB is already providing the majority of funds for the EFSF, who is going to provide the funds for the ESM?
We think the ECB will remain the most likely source of liquidity for the eurozone’s rescue funds, either indirectly via the banking systems, as in Greece and Spain, or directly via asset purchases. While not joint and several, ESM bonds will become the closest thing to eurobonds the eurozone has had. And should the ECB need to embark on quantitative easing, purchasing ESM bonds in combination with activation of ESM lending to member states is one way of addressing the difficult issue of which assets to purchase.
Super SIVSome investors remain wary of structured investment vehicles (SIVs), which helped finance the off-balance-sheet shadow banking system of the past decade, and may shy away from buying ESM bonds because, like SIVs, they would effectively allow eurozone governments to create off-balance-sheet debt. The ESM is owned by the 17 eurozone member states and will be authorized to lend up to €500 billion to these stakeholders and banks domiciled in their jurisdictions. The 17 stakeholders will pay in capital worth €80 billion to the ESM by early 2014, and Eurostat will record these capital payments as an increase in their public debt. But because the ESM will be established as an intergovernmental organisation under public international law, the €500 billion of lending capacity will not be attributable to its owners, as it would if they were to individually raise the money for loans themselves.
This reduces public debt statistics. For example, compare the EFSF’s loan to Spain to recapitalise its banks to an ESM loan. The EFSF has granted Spain a loan worth up to €100 billion to recapitalise its banks. Upon receipt of the funds, the Spanish government on-lends them to its banks, and Eurostat records the loan as an increase in Spain’s government debt (by €100 billion). Were instead the ESM to lend the same banks €100 billion, Spain’s government debt would not increase at all: On its balance sheet the ESM would record an asset in the form of a stake in the Spanish banking system and a liability in the form of an IOU to whoever lent it the funds, but none of the ESM’s sovereign stakeholders, including the Spanish government, would record an increase in its public debt.
By having the ESM lend directly to banks or buy government bonds in the secondary market, eurozone governments can create debt without recording it in their national accounts. While this is good in the sense that it severs the link between banks and their sovereigns, it is not good from a transparency perspective. Eurozone governments can, via the ESM, create debt worth up to 5% of eurozone gross domestic product (GDP) without increasing their own public debt. This is financial engineering at its best but there is no free lunch when it comes to creating debt. Markets will likely see through this super SIV nature of the ESM and price its debt (as well as the debt of its stakeholders) accordingly. We would therefore not be surprised if large-scale ESM bond issuance ends up having a detrimental effect on other European sovereigns’ borrowing terms.
End of the road
Which brings us to crowding out. Suppose the ESM lends money to Spain. Will investors then buy the bonds of the ESM’s remaining stakeholders knowing that their implicit share of ESM debt is also rising? The stakeholders are only liable for the ESM’s debt up to their share of its capital subscription, but as markets learned in 2008, one cannot financially engineer away debt; it has to be allocated somewhere. This is especially relevant for the ESM’s weaker stakeholders. Investors’ demand for bonds that could be freed up if Spain loses market access, for example, will not automatically flow to the ESM. The ESM would instead compete for a finite amount of demand for European government bonds along with its stakeholders. So long as the fundamental issues about the future of the eurozone remain unsolved, the extra supply of ESM bonds will likely drive up the borrowing costs of its weaker stakeholders.
Crowding out can almost certainly be expected in the case of the bonds of the country to which the ESM will lend because of its seniority status. The more money public sector organisations like the International Monetary Fund and ESM lend to a country on a senior status (and this also applies in the case of the ECB, which negotiated senior status on its purchase of Greek government bonds), the lower the expected private sector recovery rate on that country’s government bonds. The lower the expected private sector recovery rate, the higher the yield to compensate private investors for potential losses and subordination. The ESM’s senior lending status will likely deter private investors from buying bonds of other eurozone member states that might receive ESM financial assistance. So rather than crowding in private sector investors, the seniority of public lenders can accelerate capital flight. And once a sovereign loses market access and becomes fully dependent on official sector loans, it can be a long road back to financial autonomy.
Democratic legitimacy
The automaticity with which the ESM can place capital calls on its stakeholders has the potential to severely disrupt the normal functioning and sovereignty of governments’ budgetary processes. Consider the following: Suppose both Spain and Italy were to lose market access and apply for financial assistance from the ESM, but the ESM has exhausted its lending capacity, requiring stakeholders to provide additional capital. Because Spain and Italy (in this example) as well as Greece, Ireland and Portugal have lost market access, these five countries would not be in a position to provide the ESM with additional capital, leaving the burden to fall on remaining stakeholders.
The ESM’s treaty appears to allow this. Article 9(2) enables the Board of Directors to “call in authorised unpaid capital by simple majority decision” to restore the €80 billion level of paid-in capital if it is reduced by losses. Article 9(3) enables the Managing Director to “call authorised unpaid capital in a timely manner if needed to avoid the ESM being in default” and requires ESM stakeholders to “irrevocably and unconditionally undertake to pay on demand any capital call made on them by the Managing Director…within seven days of receipt.” Article 10 enables the Board of Governors to “review regularly…the maximum lending volume” and “to change the authorised capital stock.” Finally, Article 25(2) states that “If an ESM Member fails to meet the required payment under a capital call made pursuant to Article 9(2) or (3), a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid in capital needed.”
These articles would have two important implications if all five countries in our example were to lose market access. First, capital calls could overwhelm the financial capabilities of those ESM stakeholders retaining market access, necessitating them to implement a mix of potentially large budget expenditure cuts, tax hikes or increased borrowing in order to fulfil precommitted obligations to the ESM. Second, while the ESM’s treaty limits its “initial maximum lending volume” to €500 billion, the treaty provides neither an upper boundary to further capital calls nor an exit clause from additional capital calls over and above initial commitments. Even though national parliaments can veto additional capital calls, the treaty lacks a resolution mechanism to reconcile the ESM’s demands with the desires of taxpayers who might end up shouldering a disproportional burden of the ESM’s capital – another aspect of the ESM that remains unclear.
For example, Germany’s capital subscription to the ESM is initially capped at €190 billion. Hypothetically, Germany’s parliament could have to stump up its full capital subscription in a short space of time. But where would the money come from? Germany’s annual federal budget currently amounts to about €300 billion and is already stretched. Since reunification in 1989, net borrowing averaged €54 billion per annum, and Germany achieved a budget surplus only twice: in 2000 thanks to a stock market bubble that boosted one-off receipts from selling mobile phone licences, and in 2007 at the peak of unsustainable credit-fuelled growth (Source: IMF). The government currently spends about €80 billion per year to subsidize its public pension system. A further €40 billion goes to subsidize the labour market, while another combined €40 billion of tax revenue is transferred to Germany’s state governments and the European Union’s budget. Around €33 billion is spent servicing old debt (Source: Bundesregierung). Given current revenue and expenditure patterns, Germany would most likely have to borrow more money to fund a capital call of that size, which would likely further damage its credit quality.
Suppose the ESM expires its initial €500 billion lending capacity. How much could future capital calls amount to? Past behaviour gives an indication. Since 1989 the new net borrowing requirement of the eurozone’s southern countries averaged €95 billion per annum, and the combined budget was in deficit every single year, owing mainly to Italy (Spain balanced its budget throughout the property boom). Last year alone the southern eurozone’s combined budget deficit was €181 billion. That is just net new debt. We expect gross bond issuance this year in Spain and Italy alone, which includes the refinancing of their €2.6 trillion stock of old debt, to be about €300 billion. So, if Spain and Italy were to lose market access, a revised capital key as implied by Article 25(2) might put Germany’s share of future ESM capital calls at about 45%. And if the southern eurozone countries’ budgetary behaviour patterns do not change, resulting in the ESM assuming their borrowing requirements, Germany might then be looking at adding between €40 billion and €80 billion in net new debt each year to fund the ESM. To be sure, such a drastic turn of events is unlikely. That said, a worst-case scenario of the exercise of the ESM’s Article 10 could quickly exhaust Germany’s €190 billion initial capital subscription. And Germany can’t rely on France, the eurozone’s second-largest economy, for help. France’s net borrowing last year exceeded the amount of the other five northern eurozone countries combined.
When one considers the inefficiency with which Greece and Italy’s governments operate, according to the World Bank’s calculations, and the large estimates of their shadow economies, there seem to be clear risks to committing the eurozone’s taxpayers’ future revenues to the ESM. Markets and proponents of political and fiscal union, including myself, tend to overestimate Germany’s ability to subsidize southern Europe. Without a cap on or exit clause from additional capital calls, the ESM could lead northern eurozone countries down a difficult and unsustainable path.
We therefore believe the ESM needs to be viewed as a milestone in a journey toward a common eurozone budget and full mutualisation of government debt within the eurozone, in which economically stronger countries will end up transferring financial resources to weaker countries, albeit without direct voter participation. Once you flirt with inflation, it will marry you; once you start subsidizing, it’s hard to turn off the tap.
With doubts about the ESM’s ability to sustainably lower the long-term borrowing costs of vulnerable eurozone countries, and with the ECB indicating it will intervene to keep Spain and Italy’s short-term borrowing costs low, the credit curves of eurozone peripheral government bonds are set to remain steep. We fully expect the ESM will make progress in resolving the eurozone debt crisis by severing the link between banks and sovereigns. But so long as those countries that stand to benefit the most from ESM support do not reform, improve the efficiency of their public sectors, realize losses in their banking systems and regain international competitiveness, the ESM could weaken the rule of democracy and wreak havoc on the balance sheets of even the strongest economies.