background image

Why no country wants to access the European Stability Mechanism. The example of Italy.

Bonds

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[1]. 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[2] 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[3]. 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[4]. 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[5]. 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.

 


[1] https://www.consilium.europa.eu/media/44011/20200508-pcs-term-sheet-final.pdf

[2] https://www.mef.gov.it/covid-19/Sanita-e-Protezione-Civile/

[3] http://www.salute.gov.it/portale/temi/p2_6.jsp?id=4752&area=programmazioneSanitariaLea&menu=d

[4] Paragraph 6.2.1,b.; https://www.esm.europa.eu/sites/default/files/general_terms_15122015_clean.pdf

[5] https://www.esm.europa.eu/lending-rates

Disclaimer

Confidentiality and Usage:
You may not reproduce, distribute, or transmit this material or any portion thereof without prior written permission from Saxo.

Nature of Information:
The information provided herein is based on current market conditions and analysts' opinions, which may reflect personal views of the author, and are subject to change without notice. This material does not include a record of any trading prices, or an offer of, or solicitation for, or endorsement to enter into any transaction in any investment product. Any forecast on the economy, markets and economic trends of the markets provided is not necessarily indicative of the future or likely performance of the investment product subject of this material.

Responsibility and Liability:
Saxo accepts no liability for any use that may be made of these comments or for any consequences that arise from such use. Saxo does not guarantee the accuracy or completeness of any information provided and assumes no liability for any errors, omissions, losses, or damages resulting from the use of this information.

The information provided in this material is solely for information only. It is intended for general circulation and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. Accordingly, it should not be relied on or treated as a substitute for specific advice concerning specific situations of any person. Please seek advice from a financial adviser regarding the suitability of any investment product taking into account your specific investment objectives, financial situation or particular needs before you make a commitment to purchase an investment product. In the event that you choose not to seek advice from a financial adviser, you should consider whether any investment product mentioned in this publication is suitable for you.

Notwithstanding the above, insofar as any information provided herein contains research analyses or reports concerning any investment product authored by any foreign research house and is issued or promulgated to a person in Singapore who is not an accredited investor, expert investor, and/or institutional investor, Saxo Capital Market Pte. Ltd. accepts legal responsibility for the contents of this material to the extent required by law. Recipients of such material are to contact Saxo Capital Markets Pte. Ltd. in respect of any matters arising from, or in connection with, this material.

Risk Disclosure:
Trading in investment products involve significant risk, including the risk of losing your entire investment. Historical returns are not a guarantee of future returns. Prices can both rise and fall, and there is a risk that you will not get back the money you invested.

Conflicts of interest:
The author may hold positions in the investment products mentioned. The author does not own positions in the underlying investment product exceeding 0.5% of its market capitalisation, save as otherwise declared. The author is not permitted to trade the mentioned investment products within the first 24 hours after the publication of this article.

Saxo maintains partnerships with companies that compensate Saxo for promotional activities conducted on its platform. Additionally, Saxo has agreements with certain partners who provide retrocession contingent upon clients purchasing specific investment products offered by these partners. While Saxo receives compensation from these partnerships, all content is conducted with the intention of providing clients with valuable options and information.

Publication details:
If any listed companies are the subject of the material, the content has not been submitted to the companies in question prior to publication.

Please refer to our full disclaimer and notification on non-independent investment research for more details.

Saxo Markets
88 Market Street
CapitaSpring #31-01
Singapore 048948

Contact Saxo

Singapore
Singapore

Saxo Capital Markets Pte Ltd ('Saxo Markets') is a company authorised and regulated by the Monetary Authority of Singapore (MAS) [Co. Reg. No.: 200601141M ] and is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms & Risk Warning to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Saxo is part of the J. Safra Sarasin Group.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as Margin FX products may result in your losses exceeding your initial deposits. Saxo Markets does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Markets does not take into account an individual’s needs, objectives or financial situation.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-sg/about-us/awards.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website are not intended for residents of the United States, Malaysia and Japan. Please click here to view our full disclaimer.

This advertisement has not been reviewed by the Monetary Authority of Singapore.

Apple and the Apple logo are trademarks of Apple Inc, registered in the US and other countries and regions. App Store is a service mark of Apple Inc. Google Play and the Google Play logo are trademarks of Google LLC.