Why no country wants to access the European Stability Mechanism. The example of Italy.
Fixed Income Strategist, Saxo Bank Group
Summary: The European Stability Mechanism (ESM) is an obsolete facility that endangers the sovereignty of European Union members. Dilution risk, a rise of government funding costs and stigma are some of the threats a country runs into for getting cheap financing. We find that European countries are better off raising money in the capital market rather than applying for a loan to the ESM.
The European Stability Mechanism split people's opinion. The argument that many make it's straightforward: the ESM provides cheap loans, hence why shouldn't European members take advantage of it? Well, the issue here is that the ESM is not a charity institution giving out loans to needing countries. The ESM is lucrative, precisely like a bank, and it gives out cheap loans in exchange of fees and economic commitments.
How does the ESM works
To understand why European countries are deciding not to access this facility, it is necessary to know how the ESM works and what is written in the loans' footnotes.
Firstly, the ESM facility gives out loans only for Covid-19 related expenditures, which have already incurred. It means that a country needs to increase its fiscal deficit first, then it will be able to request a loan.
Secondly, the maximum amount that a country can request is up to 2% of 2019 GDP. In the case of Italy, last year’s GDP was around €1.8 trillion; hence the country could apply for approximately €36bn to the ESM. Italy will not receive this money on one go; the ESM will dilute disbursements over several months as the debtor can obtain only up to 15% of the overall amount at the time. Hence, for Italy, it will take around seven months to get the full amount.
The country will not be able to ask the ESM for the full €36bn because it didn’t spend that amount for the Covid-19 emergency. According to the Ministry of Economy and Finance, Italy has so far allocated €9.5bn to strengthen the health care system in light of the Coronavirus pandemic. On top of it, the budget for the National Health Services in 2019 was around €114bn. Hence, it will be hard for Italy to justify that 30% of its health budget comes solely from Covid-19 related expenses.
Why it doesn’t make sense to access the ESM facility when a country can finance itself in the capital market
ESM’s loans are incomparable to sovereign debt precisely for the same reason why you wouldn't compare the cost of your mortgage to the cost of your car loan. Below I explain what is the difference is between the two and why it is preferable to finance government deficit directly from the market.
- ESM loans are senior to sovereign creditors. This brings dilution risk, which can negatively affect the debt structure of the country that taps into the facility. In practice, this means that to get just €9 bn Italy has to give priority over its obligation to the ESM before any other creditor holder of its sovereign debt. This leads to a change in the country's debt repayment structure which will force sovereign creditors to demand more yield as they have now privileged creditors before them. Hence, the tradeoff to get €9bn cheap from the ESM causing a repricing of €2 trillion worth in Italian government bonds is not only expensive, but it is also damaging. To put it in numbers, lets assumes that Italy saves 80bps over a €36bn loan. The total saving is of €288mil. However, BTP creditors now demand 2 more basis point over €2tr sovereigns, this will potentially cost the country around €400mil.
- The ESM imposes conditionality; sovereign debt doesn't. This is a pretty huge point. The borrowing country will need to be placed under special surveillance in order to secure repayment. The ESM will enforce economic and fiscal conditions to ensure that the loan will be repaid. The same doesn't happen when a country raises money with government bonds.
- The interest rate on ESM loans is variable, and it depends on the funding strategy of the facility. As we explained in an earlier article, Spain borrowed from the ESM at a lending rate of 40bps in 2013, but it ended up paying 100bps in 2014 as the funding strategy of the ESM shifted from issuing short term to long term securities. When issuing BTPs, Italy can choose a convenient maturity and its cost of funding which is something it will no be able to do with the ESM.
- Accessing the ESM will mean declaring that the country is in financial instability, which gives an entirely wrong picture of the Italian situation. Italy can access the capital markets without problems and has no funding issues.
In conclusion, it is wrong to compare ESM loans pricing with sovereign yields because they are not comparable. The only way to appreciate the convenience of the ESM is to compare it to the price of a syndicated loan with seniority over the BTPs .
The price of that loan will certainly be lower compared to BTP yields. And even though it will not be as cheap as accessing to the ESM, a country would rather pay more than paying the cost of stigma.
Right now, Italy can finance itself at the lower interest rates the country has ever seen in history. At the moment of writing, the country benefits of negative interest rates for 3-year maturities, while it pays only 12bps for 5-year debt. Yesterday, the country issued €8bn 30-year BTPS in a blink of an eye, with books reaching €90bn in demand. It definitively doesn't look like a country on the brink of default; actually, it's drowning liquidity.
Within this context, ESM financing looks very much like Snow White's apple: perfectly round and red but poisoned. Don't get me wrong. I am at core a firm believer and supporter of the European Union. However, it is clear that the ESM is an outdated tool created for countries in financial distress in the high of the 2012 banking crisis.
Suppose the European counterparties really want to provide cheap financing to countries that are incurring rising Covid-19 related expenses. In that case, they should rethink the ESM framework. If, for example, the ESM was to accept pari-passu status with sovereign creditors, this would resolve many things. However, the issues related to the stigma will continue to weight on a country's cost of funding, making the ESM still unviable.
With the second wave of coronavirus hitting Europe, the EU might not have an alternative rather than issuing joint debt instruments and get rid of such obsolete frameworks.
 Paragraph 6.2.1,b.; https://www.esm.europa.eu/sites/default/files/general_terms_15122015_clean.pdf
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