Thursday, 21 March 2019

Providing a safety net

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Questions remain over the roles of the EFSF and ESM and whether they can really end the eurozone crisis for good, but for now the bazooka has done its job.

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The decision taken by the Eurogroup in March this year to run the European Financial Stability Facility and the European Stability Mechanism in parallel for a year has two key elements, both relating to confidence building.

First, it provides a permanent structure for a European bailout mechanism in 2012, one year earlier than formerly announced. Once ratified, this will be a fully fledged European institution, providing bankers with greater confidence that a structural safety net is in place in the event of a European sovereign meltdown.

Second, it enables the European authorities to go to the G20 with a €700bn “bazooka” as an indication of its commitment to the IMF which has been a key participant in funding the support of troubled European sovereigns.

When looked at more closely, the firepower in this bazooka is not quite so large. The parallel running of the EFSF and the ESM, which brings their aggregate lending power up to €740bn, lasts just one year, that is until July 2013. After that, the EFSF component falls away, leaving just the €500bn ESM to carry the burden of rescuing Europe’s troubled economies.

This doesn’t dint the enthusiasm for the structure of Michelle Bradley, a director in Credit Suisse’s European interest rate strategy team.

“Over the course of the crisis, there were demands that the ESM be brought forward to mid-2012. There would be a period where the two run together. This was driven by market pressure to have the bazooka bailout in place.”

Market concerns about the temporary EFSF are alleviated says an EFSF spokesman. “The ESM is based on a treaty. It will have a broader function, for raising capital from markets. The use of the EFSF is not consistent with the new ESM design. So the Eurogroup will keep the €240bn of commitments for the EFSF and shut it down at the end of the year, using the new facility as a means of injecting liquidity into the system.”

However, the EFSF retains its role of funding existing programmes, for Greece, Portugal and Ireland, but will take on no new lending programmes.

Access to the EFSF’s guaranteed allocation of funds enhances the ESM’s competence to deal with a large crisis. This brings the total of funds available to the two entities to some €700bn, composed of the ESM’s €500bn and the unallocated €200bn of the EFSF’s €440bn lending capacity. The EFSF has outstanding commitments of €240bn for the bail-outs of Portugal, Ireland and Greece. 

The ESM’s €500bn lending facility has over-collateralisation to the tune of €780bn, a move further designed to boost confidence.

“The structure is over-collaterised, to show markets that even if member states have problems providing liquidity, there is enough capital in the system so that other countries can step in and provide additional capital,” said Diego Valiante, head of research at the Centre for European Policy Studies.

The EFSF is actively fundraising to hit its €240bn target, but it must also ensure it does not tread on the toes of the ESM or its member countries. “Because the EFSF is in competition with the ESM to raise capital, it is raising it now, with a maturity of 15 years,” added Valiante.

Capital-raising by ESM country participants can shortly be expected and this will take place in five tranches between July 2012 and July 2014 and amount to €80bn.

“By widening the initial remit of the EFSF, politicians have created uncertainty as to what the guarantees of the EFSF could be used for next”

This capital-raising will take place earlier than expected, something Michala Marcussen, head of global economics at Societe Generale, welcomes. “It is an advantage that they have brought forward the capital-raising. It would be very cumbersome if member states encountered problems and before any assistance could be disbursed everyone had to raise capital and pay in capital. You need to have the firepower there when you need it; you don’t want to be scraping around for it in the midst of crisis. This may be a smaller point thing but it strengthens the structure.”

The ESM looks stronger than the EFSF because of its capitalised structure, says Credit Suisse’s Bradley. “The ESM has a more robust structure than the EFSF because there is paid-in capital, but it faces a similar battle to the EFSF with regards to accessing funding.”

The ESM will be regarded as the primary support mechanism from July 2012 for new casualties of the crisis. However countries already in a programme requiring lines of credit or additional purchases in the market will be directed to the EFSF, say bankers.

Structural changes

Concerns about the changing role of the EFSF have triggered the structural changes. The EFSF was launched as a mechanism for providing finance to countries who could not borrow from the capital markets. Its remit was subsequently widened to include buying bonds in the primary and secondary markets through the creation of a special purpose vehicle. The addition of a first loss insurance provision covering 20% of the loss experienced by investors in certain sovereign paper is a further string to its bow.

Uncertainty over the ultimate guarantors for the insurance has concerned the market. The number of countries standing behind the policy will fall as countries receiving support are exempt.

“By widening the initial remit of the EFSF, politicians have created uncertainty as to what the guarantees of the EFSF could be used for next. The idea of first loss insurance was a negative move. If you came to a position where these first losses pieces had to be paid out, what countries would be left to guarantee the EFSF? It highlighted the contagion issue,” said Credit Suisse’s Bradley.

‘‘Some investors see this as a European sovereign CDO, so there is some uncertainty around the EFSF. It is not known how much it is going to issue in any given year, or whether there will be further use of resources. It is also not known what issue proceeds will be used for, buying bonds or lending,” said Justin Knight, UBS’s head of European rates strategy in macro research.

Despite the newly enlarged firepower, market scepticism about the ESM’s fundraising capacity remains.

“The real question for the ESM is whether it can issue enough debt if Italy and Spain collapsed. The EFSF is struggling to achieve low borrowing rates at longer maturities in relatively small amounts, so it might be difficult for an entity combining the borrowing power of the EFSF and ESM to issue in amounts that would equate to their combined size. Were a country like Spain or Italy to request aid, the financing needs would be so large, and the markets so stressed that it would be very difficult for the EFSF to raise those funds. I wouldn’t have thought the ESM could raise €500bn in a crisis,” said Knight.

Germany in the line of fire

The new structure puts Germany in the line of fire, said SG’s Marcussen. The EFSF and the ESM are well suited to providing financial assistance to smaller countries in the eurozone where necessary. The structure, however, is less well suited to tackling a problem in a large member state should the need arise. At present, the structure does not have the capacity to tackle both Spain and Italy, if such a risk scenario were to emerge.”

Funds required for a bailout of Spain and Italy far exceed the anticipated lending funds available to the ESM. Indeed, Alessandro Giovannini, an associate at the Centre for European Policy Studies in Brussels puts the number as high as €1.5trn.

“It would be impossible to do this through paid-in capital and the guarantees as through the ESM. It would not be sufficient to just increase the paid-in capital and guarantees.”

The prospects for fundraising by the ESM are not overly helped by history. Bankers cited the EFSF’s experience last November, when, in difficult market conditions, it chose not to sell a long 10-year bond, only to return a week later at a wider spread with a €3bn transaction that just crept over the line with the aid of some lead manager retention for “technical reasons”.

All this was a far cry from its debut in January 2011, when it attracted €45bn of demand on its €5bn five-year, although things have been showing marked signs of improvement this year.

In March 2012, the facility completed a notable hat-trick when it raised nearly €7.5bn from three deals across the maturity spectrum in the space of as many days. The funding spree began with a €1.5bn 20-year issue on the Monday, then came a six-month bill offering of just under €2bn on Tuesday, and a €4bn five-year deal on Wednesday.

Demand for the two syndicated issues, which was seen as a key test of investors’ attitudes, reached €17.6bn. Both consequently priced inside initial price thoughts – the five-year deal at 38bp over mid-swaps, from talk of the mid-to-low 40s and a revision to the 40bp area, and the 20-year issue at plus 115bp from the 120bp area. 

However, not all are convinced, and a lack of confidence in EFSF paper undermines its capacity to raise funds at the prices attained by other Triple A rated institutions, according to Valiante.

“The bonds are underperforming the markets. They are performing like France. The interest rates are similar to France and they are not truly Triple A. The market doesn’t trust the EFSF.”

Nonetheless, the willingness of the market to take three EFSF issues in a week shows that in its short life the institution has experienced giddy enthusiasm with its first issue, then doubt in late 2011, ending with mature sensibly priced demand. Questions remain about how the EFSF will operate and in turn the ESM, but the authorities have shown commitment to the structure in place. The size of the bazooka is less important than the confidence it engenders and few right now have the temerity to test it. The hope is that this remains the case if Spain and Italy come knocking.

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