Europe's crisis solution on course to be huge problem
OPINION: Domestic implications of new stability mechanism likely to mean major heartache for euro zone members
DID EUROPE’S leaders save the euro last week? There is good news, bad news and really bad news.
The good news is that a new permanent crisis resolution mechanism has been put in place, starting in 2013.
This European Stability Mechanism (ESM) will be a supranational institution, established by international treaty.
By mid-2017, it will be properly funded, with a fully paid-up capital base of €80 billion.
This should be sufficient for a fund with a lending ceiling of €500 billion. So, from 2018, the euro zone will be able to tackle future crises.
The bad news is that the various resolutions made this week by European Council will not be enough to carry us through the current crisis.
The discussion about the ESM is also a perfect case study of what is going wrong at the moment. It therefore merits closer scrutiny.
Early last week, European finance ministers agreed a relatively straightforward capital structure for the ESM.
It would have a total capital of €700 billion, of which €80 billion would actually be paid in.
The rest would be “callable” capital. This means that the fund can ask shareholders to supply new capital, if existing capital gets wiped out.
The problem with callable capital is a “can’t-pay, won’t-pay” scenario, since the member states all guarantee each other.
For example, do we really believe that Italy – a country with public sector debts of 120 per cent of gross domestic product – is in a position to find tens of billions for the bailout of another member state?
Italy’s share in the ESM is nearly 18 per cent, slightly less than France, at 21 per cent.
If something bad happens, Italy would share a big responsibility. What if Italy, or indeed somebody else, cannot honour its commitment?
The idea behind the paid-in capital is to provide a buffer, so that the system can deal with problems more easily.
But the idea of a properly funded ESM suffered a surprise setback last week.
German MPs suddenly panicked at the prospect of having to put up €11 billion in 2013 – an election year, for which Germany’s ruling coalition had earmarked a tax cut.
So Angela Merkel went to Brussels on Thursday and demanded that there should be no upfront payment, and that money would be phased in over five years, instead of three.
To comply with the rule that the paid-in capital has to be at least 15 per cent of the ESM’s loan volume, the German chancellor agreed to provide additional resources if that became necessary.
But here is the crux: Germany and France, whose sovereign bonds have a triple-A rating, would not need to put up actual money to cover any shortfall of paid-in capital.
A guarantee would do. But countries with lower ratings, such as Italy, Spain, and, yes, Portugal, Ireland and Greece, would have to pay cash.
So we are in a perverse situation.
Countries with easy access to capital can provide cheap guarantees, while the weaker countries must put forward cash.
In fact, the biggest risk to Italy’s future solvency has nothing to do with its own debt. It is the country’s exposure to the euro zone crisis mechanism.
Moreover, since this guarantee has to serve as the equivalent of a prepaid cash payment, a guarantee by a non-triple-A rated country would not cover the shortfall.
I understand that the summit just fudged this issue: the Italians walked away from the table with a different understanding of what had been agreed.
Of course, all of this might not matter.
It is conceivable that most lending operations will be agreed before 2013 under the existing mechanism – the European Financial Stability Facility (EFSF).
It runs out in that year, but all loan tranches paid until then will continue under the old umbrella.
Because these will not be transferred to the ESM, the new mechanism might get a little breathing space. And countries will also have time to put up the capital.
But just imagine if one of EFSF’s debtors defaults. The EFSF has no capital, only guarantees.
So the success of the exercise would depend on the creditors’ ability to make good on their promises, without getting themselves into trouble.
This would be a highly strung exercise. The EFSF’s credit has equal status to privately held bonds.
This means that if a country defaults everyone gets hit equally.
Governments would have to pay immediately. What is intended as a rescue mechanism would then unwittingly become a crisis propagator.
This is why it is so important to establish a mechanism with enough paid-in capital from the outset, rather than relying on guarantees.
It would also have been a good idea to fold the EFSF into the new mechanism right from the beginning, rather than letting them coexist.
But now for the really bad news: the domestic political systems in the euro zone’s members are not prepared for what is about to hit them.
If the German coalition convulses at the prospect of an €11 billion capital injection, what might they say if confronted with a much larger request to make good on a loan guarantee?
Unlike a simple capital provision for the ESM, the payment of a guarantee would require an offsetting fiscal correction at home.
Just imagine the politics of a cross-border bailout that requires a cut in domestic welfare payments.
The irresistible force of EU-level crisis resolution will eventually come into conflict with the immovable object of national politics. Last week’s debate on the ESM is an early warning of what lies ahead. – (Copyright The Financial Times Limited 2011)