THE EUROPEAN Financial Stability Facility was created in panic in the course of a frantic weekend in May last year. Now it is set for a second overhaul in less than three months. This part of Europe’s “firewall” against the risk of contagion from Greece is designed to protect distressed sovereign states.
THE PROBLEM
The EFSF is too small. Its lending capacity has been increased to €440 billion but this would not be enough to prop up Italy or Spain, never mind the two of them together. EU leaders have already moved to give the EFSF the power to buy up sovereign bonds like the ECB. Again, however, the fund is not large enough to give doubters confidence that it can continue intervening in markets for as long as it takes for Europe to ride out the storm.
Also, the ECB wants to end the bond-buying campaign which has stoked deep divisions within its top management.
This is one of the key tasks facing incoming ECB president Mario Draghi.
THE FIX
The solution lies in “leveraging” the EFSF’s assets so Europe makes better use of the money in the fund. This has the advantage of not requiring an upfront increase in the guarantees countries give to the EFSF, meaning leaders are not confronted with garish headlines about an increased draw on funds.
There is a sleight of hand here, however. Euro zone countries would still be on the hook for any losses the EFSF incurs.
Many proposals were tabled, among them the suggestion that the fund provide cross-guarantees to the ECB to insure it against losses on its bond-buying. The ECB rejected that. The bank also ruled out the notion that the EFSF be given powers to draw down big ECB loans like a commercial bank.
Under discussion now is whether the EFSF will be deployed to provide a form of insurance to bondholders. In essence, investors who buy bonds directly from a distressed country when it goes to the market would be protected against a 20 per cent or 30 per cent loss. A key advantage here is that the money is not deployed in the first instance. But Germany remains to be convinced.
By whatever means, any increased use of the fund increases the risk to the guarantees it provides.
In addition, there is concern to avoid a situation in which the availability of EFSF “leveraging” encourages countries to rest on their laurels without confronting their financial problems. Italy is a case in point.
WATCH OUT FOR
Separately, moves are in train to bring forward by a year the introduction of a permanent new fund – the European Stability Mechanism – which was to succeed the EFSF in mid-2013.
It is a condition of any ESM aid that bondholders must bear losses. If this fund is introduced in mid-2012, it would increase the prospect that other countries might meet the fate of Greece.
However, the funding structure of the ESM gives it more flexibility from the off. In addition, its early introduction would remove some of the pressure on the EFSF.
