ESM loses all its teeth
December 7, 2011 4 Comments
Following German Chancellor Angela Merkel and Sarkozy’s press conference on December 5th, most of the focus has been on the treaty changes proposed, including not-quite-automatic sanctions for profligate countries that miss their budget targets and the implementation of golden rules in country constitutions. The most important announcement went largely under the radar—that the European Stability Mechanism (ESM) will not force losses on private bondholders. This transforms the ESM from a vehicle that might have actually helped (though many details were still needed) to yet another insufficient bailout mechanism that is poised to sink even the core EZ countries.
The ESM as it was originally announced in 2010 was different from the existing bailout fund, the European Financial Stability Facility (EFSF), in two important ways. First and foremost, under the ESM a debt sustainability analysis would be conducted on all EZ countries. Those countries deemed to have liquidity problems would receive bailouts, and those deemed insolvent would have bail-ins in accordance with IMF guidelines (whatever that really means. As @alanbeattie regularly remarks the IMF does not have guidelines for this sort of thing). The ESM also differed from the EFSF in that the former is to consist of around €700bn in paid in capital and callable capital (for a lending ceiling of €500bn, see ESM treaty, p19) whereas the latter is not pre-funded and relies solely on country guarantees.
Chancellor Merkel has backed down on forced private sector involvement (PSI) in cases in which a country is deemed insolvent. This does not necessarily mean that voluntary private sector involvement cannot take place, though it might. Merkel and Sarkozy stressed repeatedly during their press conference that the PSI in Greece should be considered a unique event and would not happen anywhere else in the eurozone. In any case, it does mean that involuntary haircuts will not be imposed on bondholders.
Without the capacity to force bail-ins, the ESM is now just a bail out facility. As such, it is slightly more powerful than the EFSF because it consists of real and not funny money. But there is a fatal flaw that both bailout facilities have in common: they both involve eurozone countries guaranteeing one another’s debt in one big, vicious circle. The latest greatest out of Brussels involves the ESM being used in addition to the EFSF, rather than the ESM taking over for the EFSF as was originally planned. This would be an absolute, sure-fire way to get S&P to make good on its threat to downgrade all 15 eurozone countries it put on negative watch earlier this week, including Germany.
Even if there are no forced bail-ins through the ESM, debt restructurings seem inevitable in the eurozone somewhere down the line. None of the solutions to the crisis mooted so far come anywhere close to providing a growth strategy for the region, without which the fiscal dynamic in the weaker countries will simply get worse. Delaying a debt restructuring may seem preferable now, but it will only amount to more pain later on. This is not only because overall debt levels will be higher, but also because the more debt held by the official sector, the bigger the haircut imposed on private bondholders.
Merkel and Sarkozy’s decision to back down from forced PSI in the ESM is a huge mistake, but it might never be implemented. The junior coalition party in Germany, the FDP, has a referendum on the ESM that is due to end on December 13th. If enough party members participate in the referendum to render the referendum valid (not a foregone conclusion) and if PSI is removed from the ESM, I think the FDP would reject the mechanism. This means that Merkel would lose her chancellor’s majority when the ESM is put to a vote in the Bundestag in Q1 2012, which could ring the death knell for the German coalition. Merkel may decide removing forced PSI from the ESM isn’t worth the trouble it could cause her directly.
For more analysis on what to expect in the weeks ahead in the EZ, check out this piece by Roubini Global Economics: Running Out of Time: Likely Path Ahead for the EZ.