As expected, the ESM will have an effective lending capacity of €500bn, but to maintain a Triple-A rating it needs to be backed up by €700bn in capital – pretty huge figures. This means that Germany will be on the hook for guaranteeing €190bn! We can’t imagine German taxpayers will be too happy about having that potential liability hanging over their heads for the next 12 years (at which point the fund will be reassessed). Moreover, given the structure of the fund, €80bn in capital must be paid in initially, meaning Germany has to pay in €4.3bn per year for the next five years – this could even increase if someone – yes we’re looking at Greece – puts in an early request for funding.
We were also wondering what would happen if one of the countries – this time we’re looking at all of the PIIGS – was unable to cover its share of the fund. The draft treaty seems slightly contradictory. First it states:
“The liability of each ESM Members shall be limited, in all circumstances, to its portion of the authorized capital at its issue price. No ESM Member shall be liable, by reason of its membership, for obligations of the ESM. The obligations of ESM Members to contribute to capital in accordance with this Treaty are not affected if such ESM Member becomes eligible for or is receiving financial assistance from ESM.”This would suggest that no country would be forced to shoulder anyone else’s burden. However, it later adds:
“If an ESM Member fails to meet the required payment under a capital call…a revised increased capital call shall be made to all ESM Members with a view to ensuring that the ESM receives the total amount of paid-in capital needed.”So in actual fact, if one or more members failed to put up their share, all the other members will be asked to cover it (with the expectation of getting it back, but, as we're beginning to see, that’s far from guaranteed in the eurozone crisis).
The treaty also contains some tough conditions for investors. First, ESM loans will be senior to all other loans except the IMF, which we expected. Second, the disbursement of any financial aid from the ESM will require “adequate and proportionate” private sector involvement (read debt restructuring or at least rescheduling) and thirdly, all eurozone government bonds issued post July 2013 must include a standardised form of Collective Action Clauses - which stop a small minority of bondholders holding up any restructuring deal by waiting for better terms.
Although this is intended to help shift the burden from taxpayers (a good thing in principle), giving investors such substantial warning is likely to turn the market for some European sovereign debt into a ghost town. Why buy new debt when you're being explicitly told that you're first in the firing line?
How this will help wean Ireland, Portgual and especially Greece off their current ECB and EU bailouts is far from clear and could turn the ESM into a self-fulfilling bailout fund.
As the conditions for bondholder involvement highlight, the ESM might eventually bring a necessary eurozone debt restructuring to fruition but by that point the write downs will need to be huge and such a large amount of the debt of peripheral countries will be owned by the taxpayer that the private sector burden will still end up being minimal.
*** Update 11am 20 May 2011:
Writing in the FT Quentin Peel suggests that the latest version of the treaty does not stipulate that ESM loans will be senior to private creditors. Having reviewed the version we have it looks as if its still mentioned in the preamble but not the body of the treaty, so it is possible that it could be removed, which would be big news. But since negotiations are ongoing its not completely clear whether it will be removed or not. We'll keep you posted on the situation...