The European Stability Mechanism (ESM) and its reform: FAQs and answers.

The European Stability Mechanism (ESM) and its reform: FAQs and answers.

(Fonte : Banca d’Italia)

The European Stability Mechanism (ESM) was set up in 2012 by means of an intergovernmental treaty, outside the EU’s legal framework. Its core function is to grant conditional financial assistance to member countries that, despite having sustainable public debts, are experiencing temporary difficulties in raising funds on the market.

The conditionality varies according to the type of instrument used: for loans, it is in the form of a macroeconomic adjustment programme, described in a specific memorandum of understanding (MoU); it is less stringent for precautionary credit lines, intended for countries with fundamentally sound economic and financial conditions that are hit by adverse shocks.

The ESM is governed by a Board of Governors (the Board), composed of the 19 euro-area finance ministers. All major decisions are taken unanimously by the Board (including those on granting financial assistance and on MoUs with countries receiving such assistance). The ESM can act on decisions taken with a qualified majority of 85 per cent of votes if, in the event of a threat to the euro area’s economic and financial stability, the European Commission and the ECB request urgent decisions to be taken regarding financial assistance.

The ESM’s subscribed capital is €704.8 billion, of which €80.5 billion has been paid in: its lending capacity amounts to €500 billion. Italy’s subscribed capital in the ESM amounts to €125.3 billion and its paid-in capital is more than €14 billion. The voting rights of Board members are proportional to the capital subscribed by their respective countries. Germany, France and Italy have voting rights that exceed 15 per cent each and they may therefore veto urgent decisions.

The proposed reform of the Treaty establishing the ESM addresses the prerequisites for granting financial assistance and the tasks to be carried out by the ESM. Overall, the changes proposed are limited in scope; the reform makes no provision for, nor does it envisage, any sovereign debt restructuring mechanism, and it does not entrust the ESM with any macroeconomic surveillance tasks.

The reform would also give the ESM a new function as a backstop to the Single Resolution Fund (SRF) within the bank crisis management framework.

1. Is it true that the ESM is of no use to Italy and in fact actually damages it?

The ESM is not an organization of no use to Italy and it certainly does not damage the country; it helps Italy just as much it helps every other euro-area country.

The ESM mitigates the contagion risks linked to possible crises in a euro-area country, risks that have materialized in the past with serious repercussions for Italy (as happened starting in 2010 with the Greek crisis, for example). The presence of the ESM reduces the probability of a sovereign default, at least for countries experiencing temporary difficulties that can be resolved with loans or credit lines (for the other countries nothing changes).
The reform, which allows the ESM to act as a backstop to the Single Resolution Fund, means the ESM would also help to limit the contagion risks linked with systemically important banking crises.

With specific reference to Italy, refinancing the country’s high public debt could take place in a more orderly fashion and with lower costs if financial market conditions remain relaxed.

2. Is it true that Governor Visco defined the reform as a ‘huge risk’?

No, the Governor argued that introducing a Debt Restructuring Mechanism would involve a ‘huge risk’; the reform of the ESM neither provides for nor envisages this kind of mechanism.

3. Is it true that the reform of the ESM would mean an automatic restructuring of debt in the event that Italy requested access to its funds?

The reform neither provides for, nor does it envisage in the future, an automatic sovereign debt restructuring mechanism. As in the current Treaty, financial assistance is not given in exchange for debt restructuring. The text of the reform clarifies that the preliminary checks on the debt sustainability of the country requesting assistance are in no way automatic (they are carried out ‘allowing for a sufficient margin of judgment’) and reiterates that private sector involvement in debt restructuring must remain limited to exceptional circumstances.

4. Is it true that the reform is designed to facilitate access to funds for countries with their public finances in order (for example Germany, in order to deal with a banking crisis) and to make access to funds more difficult for countries that do not comply with the Maastricht criteria (for example Italy, in the event of a sovereign debt crisis)?

The preconditions for accessing ESM funds (loans and precautionary credit lines) will remain essentially unchanged following the reform.

As regards loans (which are contingent on a macroeconomic adjustment programme), the preliminary check on debt sustainability (already provided for in the current treaty) would be accompanied by another check on a country’s capacity to repay the loan (already part of the post-programme surveillance). These clauses are there to protect the ESM’s resources, to which Italy is the third largest contributor.

As far as precautionary credit lines are concerned, the reform confirms the difference already set out in the current Treaty between ‘simple’ credit lines (Precautionary Conditioned Credit Line – PCCL) and those ‘with an enhanced conditionality’ (Enhanced Conditions Credit Line – ECCL). PCCLs are for countries meeting the requirements of the Stability and Growth Pact that do not have excessive macroeconomic imbalances or financial stability problems, while ECCLs are for countries that do not fully meet the above prerequisites and are therefore asked to take corrective measures.

The reform refines the criteria currently in force for accessing PCCLs and makes them more stringent. Specifically, the reform establishes that PCCLs can normally only be used by countries not subject to a procedure for excessive deficit or excessive macroeconomic imbalances, and envisages quantitative benchmarks for public finance variables. Given the more stringent requirements, signing a Memorandum of Understanding would no longer be required for the granting of a PCCL; this credit line would be granted upon receipt of a letter of intent from the requesting country.

5. Is it true that the reform of the ESM increases the probability of a sovereign default?

No, that is not true. The reform reiterates that private sector involvement (PSI) in sovereign debt restructuring must remain strictly limited to exceptional circumstances. It is in light of PSI being confirmed as an exceptional case that we should interpret the amendment to the collective action clauses (CACs), which will come into force from 2022.

According to this amendment, if a country decided to proceed with debt restructuring, a single vote by government security holders would be sufficient to amend the terms and conditions of all the bonds (‘single limb’ CACs), instead of dual votes (one for each issuance and one for the bonds as a whole). The purpose of this amendment is to make any debt restructuring more orderly, thereby reducing the costs linked to the uncertainty over how it will be done and how long it will take, which damage both the debtor country and its creditors. Yet these costs are only a small part of the overall costs of a default, and reducing them is certainly not enough to make a default more likely: the disastrous social and economic consequences of a default are the real deterrent.

As already happened following the introduction of the current CACs in 2013, this amendment, which does not increase the likelihood of a default but reduces the uncertainty surrounding its outcome, could lead to a fall in the sovereign debt risk premiums that burden the government bonds of all euro-area countries, including in Italy.

In any case, it should be remembered that the probability of a default depends above all on a country’s economic policies.

6. Is it true that, as regards the decision-making process for the ESM to grant assistance to countries, the reform increases the power of the body governing the ESM (a technical body) rather than that of the European Commission (a political body)?

Although it carries out ‘technical’ tasks, the ESM is managed by a Board of Governors, composed of the 19 euro-area finance ministers who are responsible for deciding (usually unanimously) whether to grant financial assistance to countries that request funds.

The reform does not increase the ESM’s powers, but does envisage it playing an active role in crisis management and in the process for disbursing financial assistance, as well as in the subsequent surveillance; accordingly, it indicates the tasks of the ESM’s Managing Director.

The ESM will flank the European Commission, not replace it. How the two institutions cooperate will be set out in an agreement to be signed when the amendments to the Treaty come into force. The terms of the provisional agreement reached between the two institutions in 2018 are echoed in the text of the reform proposal.

The ESM’s activity is bound by compliance with EU legislation; the Commission is entrusted with checking this.

The overall assessment of the economic situation of countries and their position vis-à-vis the rules of the Stability and Growth Pact and of the Macroeconomic Imbalance Procedure remains the exclusive responsibility of the Commission.

The ESM should not serve the purpose of coordinating economic policies among the Member States for which European Union law provides the necessary arrangements.

7. Is it true that this reform means that Italy will have to pay additional funds into the ESM?

No, the ESM’s capital will remain unchanged, as will the rules that govern any future pay-ins.

8. Is it true that if the Mechanism has to intervene in a crisis, Italy will have to pay the missing share in within seven days?

The current Treaty already says that the paying in of further capital within seven days is only envisaged in conditions of absolute emergency, i.e. in the event that the ESM might risk finding itself in default towards its creditors.

Generally speaking, the decision to request further payments of capital rests with the Board of Governors and follows the normal voting procedures. However, the ESM’s Board of Directors can decide by a simple majority on payments to cover any losses that have reduced the level of paid-in capital. The reform does not affect these aspects.

9. Is it true that with this reform, neither the ECB nor the European Commission will be able to intervene in a crisis without a decision from the ESM?

The reform makes no changes in this regard.

The presence of ESM financial assistance (in the form of a loan accompanied by a macroeconomic adjustment programme or an ECCL) has always been a necessary condition for the ECB to intervene in the secondary market for a country’s government securities (using Outright Monetary Transactions – OMTs).

As regards the European Commission, the instrument at its disposal was and is the European Financial Stabilisation Mechanism (EFSM), which was set up in 2010 with a lending capacity of €60 billion and used to provide assistance to Ireland and Portugal. Now that the ESM is fully operational, the EFSM is only used for specific tasks, such as extending maturities on outstanding loans and granting bridge loans.