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Over recent weeks, Spain has entered a “shadow” troika programme: In return for up to €100 billlion in aid to recapitalise its banks, Spain has agreed to a clear set of financial sector reforms. Less visible is Spain’s commitment, as part of the bailout, to implement the European Commission’s recommendations on fiscal and structural reform, with quarterly monitoring. This macro-conditionality is less taxing than those demanded of Greece, Ireland and Portugal. However, the reality is that Spain has ceded fiscal sovereignty, and this is a positive step toward resolving the euro debt crisis. Ceding sovereignty results in greater eurozone fiscal coordination, a necessary prerequisite for greater financial solidarity. Now that Spain has done its part, its eurozone partners need to agree to policies that lower Spain’s debt costs to sustainable levels. As a first step, we believe they should make good on their eurozone summit agreement to use the European Financial Stability Fund (EFSF) and European Stability Mechanism (ESM) instruments in a “flexible and efficient manner” to stabilize eurozone sovereign markets. Without this decisive policy response, Spanish voters will likely reassess the decision to cede sovereignty and the euro debt crisis is likely to continue.Capabilities of the EFSF and ESMThe ESM is not currently operational and will remain unavailable until the German constitutional court rules on its legality on 12 September 2012. So the EFSF remains the rescue vehicle in the interim. Assuming the ESM is not stillborn, the chief difference between the EFSF and ESM will be lending capacity: The EFSF has €248 billion in remaining funds, while the ESM will have up to €500 billion. These amounts could be increased if all eurozone governments agree but this decision will require parliamentary approval in some countries.Other important technical differences will give the ESM more operational flexibility in a crisis. The ESM will be funded by paid-in capital, which requires prior national bond issuance, while the EFSF is backed by government guarantees. And over time, eurozone governments plan to allow the ESM to invest directly in eurozone banks.Both the EFSF and ESM can only intervene in a sovereign’s bond market after a request from the sovereign, with a memorandum of understanding specifying the relevant policy conditionality. When it comes to near-term crisis resolution, what matters most is how the EFSF and ESM can intervene. Here the EFSF and ESM have very similar powers: They can provide loans to governments and buy bonds in the primary or secondary markets. Lack of market capacity for EFSF issuanceThe current structure of the EFSF/ESM suffers from a number of problems. The first is the market’s lack of capacity to absorb large EFSF/ESM issuance in such a short space of time. Investors typically have lower concentration limits for supranationals and agencies than government bonds. The EFSF has dealt with this by minimizing its reliance on market issuance. Only 43% of the €97 billion in EFSF bonds outstanding were issued into the market, as shown in Figure 1. The rest were placed with institutions, such as Greek banks needing recapitalisation, which then used the bonds as collateral to obtain European Central Bank (ECB) funding. The same is likely to happen with the €100 billion Spanish bank recapitalisation.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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