Yesterday evening Eurogroup finance ministers pressed the button on the start of the European Stability Mechanism or ESM which will be the replacement for the European Financial Stability Facility or EFSF which has produced anything but! This being Europe the unstable lifeboat EFSF will continue for a while and indeed will remain for now the bigger partner to its baby brother.
It will also replace the European Financial Stability Mechanism or EFSM (apologies for all the acronyms….) of which more later.
What does the ESM bring to the party?
There is a basic improvement that the ESM brings to the party. It it is planned to have some capital to back its borrowings which the unstable lifeboat which is the EFSF never had.
However being the Euro area it is not that simple
Whilst having some capital is plainly an improvement there are three main problems with it as it stands.
1. The paid-in capital of 80 billion Euros is only going to be 11.4% of its total capital subscription of 700 billion Euros and 16% of its maximum lending capacity of 500 billion Euros. This means that the following sentence by its head Klaus Regling can go straight into my financial lexicon. If we were playing Monopoly this is a do not pass go moment I think.
This gives the ESM a robust capital structure
2. Unfortunately the capital is going to be paid in over time when the need (Spain for example) is now. Originally the fantasists writing the documentation felt that 20% could be paid in for five years whereas it has now been speeded up to 40%,40% and then 20%. But the problem remains that it looks likely to face heavy drawdowns with much of its capital unpaid.
3. A backwards step was taken in assuming that countries in receipt of rescue programmes can contribute capital. The Mad Hatter was really enjoying his Tea Party at this point! So of it we get Greece at 2.82%, Ireland at 1.59% and Portugal at 2.51% combining to 6.92% of the capital. Thus countries in receipt of loans will have to divert some of the loans to pay their capital share to an organisation which will then lend them money. Quite bizarre and an example of the sort of financing which got us into the credit crunch and therefore is exremely unlikely to help us get out of it.
The next problem is simply that Spain is a provider of 11.9% of the capital. Yes the same Spain which has required a credit line of 100 billion Euros from its Euro area partners to help bail out its banks. So exactly how will she find the money to pay her share of the first capital tranche of 3.8 billion Euros on October 23rd? Continuing with the same logic Greece will have to pay 902 million Euros,exactly how?
Should things go wrong which on the track record so far is rather likely then we see in the words of the head of the ESM that there are three responses.
A general capital call concerns payment of the initial capital and also, if necessary, an increase of paid-in capital which could be necessary, for example, to raise the lending capacity.
I will leave readers to mull the implication that the country which has caused the need for the lending capacity to be raised will have to borrow the money off the ESM to fund its share of the ESM’s capital. There seem to be a lot of plans for what would happen if things go wrong here as we also have the possibility of these two alternatives.
A capital call to replenish paid-in capital
an emergency capital call
Now making plans for possible trouble is sound work but I for one wonder about what announcing an emergency capital call in an emergency might do to sentiment! Particularly if the usual Euro area dithering takes place.
Tucked away in all this is something that should concern the stronger nations in the Euro area. What happens if someone- for example Spain- cannot pay its capital?
If any ESM member fails to meet the required capital call, one or more revised increased capital calls would be made to all ESM Members by increasing the contribution rate of the remaining ESM Members on a pro-rata basis.
There are dangers here for Germany as she could find her share escalating upwards quite quickly. So far the small relative size of the nations involved has limited this but Spain is different and could easily fire off her own domino effect. The effect of sharing out her 11.9% could easily put Italy (17.91%) in trouble and as I pointed out only last week France (20.39%) is not as safe as her bond yields are considered by some to imply. So the crisis could spread like wildfire and we have a lifeboat which may not be as unstable as the EFSF but is way below the standards of shipwrights and boat builders.
What could go wrong?
This is simply that the ESM looks to have a lending capacity which could easily be taken up by Spain alone. Indeed the support programme for Spanish banks will drain around 50 billion of the 500 billion capacity even under the rose-tinted analysis of her bank stress tests.
This looks like being a missed opportunity and there has been a lot of debate over it.
This may seem arcane but it is actually very important. If ESM lending is as “senior” as that of the International Monetary Fund then as it lends more to a country private-sector lenders will get less and less should there be a debt restructuring as the ESM would get 100% back even if the value was say 60%. This would mean that the private-sector would have to have a restructuring where it got less than “value”. A clear example of this was what happened to Greece where private-sector holdings of Greek government debt accepted a much heavier haircut than if there had also been what is called official sector involvement or OSI.
It looks as though ESM lending will be senior in future -unlike its lending to Spanish banks- which means that should its lending to a country build up private-sector lenders are likely to exit fearing that they would face a disproportinate share of any possible restructuring. Unstable lifeboat alert again particularly if we combine it with the ESM’s capacity constraints.
Last night we got some insight into the implications of this as inspite of the debt restructuring the IMF forecast that in 2020 Greece’s national debt as a percentage of GDP under adverse circumstances or in other words reality would be 150% in 2020 i.e the whole episode was pointless mainly because official lending was excluded.
The European Central Bank
This is always manoeuvering in the background but let me point out that currently if we use the words of Arthur Daley it has found itself “a nice little earner”. Remember the LTROs where it loaned out just over one trillion Euros originally in return for at 1% of interest and now 0.75%? As of yesterday it had 290 billion Euros of that back in deposits on which it now pays nothing or to be more precise 0%. But that is not the end of it as some 533 billion Euros decamped to its current account.
So by my maths should such a situation be maintained this would produce 6.2 billion Euros of profit a year. It is not only private-sector banks that benefit in these times!
Meanwhile the poor Euro area taxpayer takes the balance sheet risk should something that would not doubt be described as “unexpected” occur. I would imagine that 99.9999999% are unaware of what is being done in their name.
The UK is a better European than is often claimed
The nation that invented the word Eurosceptic is in fact supporting the Euro right now. I did say that I would return to the EFSM of which the UK has a 12.5% shareholding (2011). This is what was announced by the Eurogroup last night and the emphasis is mine.
the Eurogroup approved the next EFSF disbursement of EUR 0.8 billion and looked forward to the adoption by the Ecofin of the legal texts paving the way for the EFSM disbursement of EUR 2 billion and to the approval of the 1.5 billion disbursement by the IMF Executive Board at the end of the month.
Has there been any discussion over this further 250 million Euro potential liability readers have spotted? Here is the official view from the House of Commons Library.
The UK faces an indirect contingent liability through its participation in the EFSM, equivalent to its share in the EU Budget.
Those of a nervous disposition may be reassurred by the statement that it is “extremely unlikely” things could go wrong. What was that again that Sir Humphrey Appleby told us about official denials?
Oh what a tangled web we weave,
When first we practise to deceive!
(Sir Walter Scott)