The European Stability Mechanism (ESM) is a financial institution founded by the Euro area countries in 2012, during the sovereign debts crisis. Its objective is to support the member States, ensuring them financial assistance in hardships, when they can’t finance themselves on the markets or the cost of issuing debt is unsustainable[1]. Nowadays, 19 countries contribute to the ESM.
To provide assistance to the Eurozone States in case of need, the ESM does not draw financial resources from the taxpayers. It raises funds directly from the markets, issuing debt securities. Its creditworthiness is proven by its own capital endowment, which is jointly guaranteed by the 19 States. Establishing the ESM, the member States have decided to commit a capital of 704 billion for it, a share of approximately 80 billion euro was paid directly and the remaining of 624 billion was subscribed by each State and it is callable by the ESM, if needed[2]. Normally, the callable part of the capital serves only as an additional guarantee for the lenders and testifies both the solidity of the ESM and the commitment of the countries. The actual contribution of these resources could be requested only in extremely serious situations. At this point, it is crucial to have clear in mind that the ESM finances the countries with resources borrowed from the markets and not using the capital contributed by the States.
Every country contributes to a share of the capital, determined considering its population and its GDP. Figure 1 shows the percentage of the capital provided by each country. The fact that its capital is financed and guaranteed by all the Eurozone countries makes it extremely safe to lend money to the ESM. For this reason, it currently issues securities with a triple A rating, the highest in the rating scale (for more information see the article What Is The Role Of Credit Rating Agencies In The Economy?).
Moreover, its financial strength allows the ESM to borrow at a lower price than any State in financial difficulties. [3]The cost of debt does not depend only on the borrower’s creditworthiness, but it is linked also to the duration of the loan. A three-year fixed-rate loan costs less than a 10-year loan with the same counterparties and conditions. Indeed, in a longer period of time, one or more fundamental variables of the financing, such as the market conditions or the stability of the debtor, are more likely to change and this could negatively affect the lender. Therefore, the lender requires a higher remuneration to bear the additional amount of risk given by the higher uncertainty.
To minimize the cost of funding, the ESM finances with short term loans, exploiting its large liquidity. This facilitates cheap lending to the Euro area countries in hardship. In addition, to make sure that the supported State has the time to recover, the loans distributed by the ESM have longer maturities than any other financing that the State could obtain directly on the markets[4].
The decisions on conceding financial support and on eventual additional contribution to the capital are taken by the Council of Governor of the ESM. The Council is a decision-making body composed of the ministers of finance of every member state. The individual ministers do not have the same voting power. The weight of every vote depends on the share of the capital owned by each state. This system allows the States that bear more risk to have a bigger impact on decisions too.[5]
WHY IS THE ESM NECESSARY?
The European Union is incomplete. Its member States have a large exchange of resources, goods and capitals, and they share a part of their economic and financial risks too. Some of them have a deeper cooperation and use the same currency, however it does not exist any sort of fiscal union yet. Decisions on the taxation systems, economic policies of any individual country and other economic interventions are taken at national level. Even if there is coordination at European level on these issues and a set of common rules, there is nothing like a European Ministry of Finance. This absence is even more significant in times of crisis, when rapid and joint reactions can avoid major problems. Thus, the ESM was created as a defensive instrument to increase the power of intervention of the EU. However, this instrument is still far from being perfect. Long and hard negotiations have been necessary before reaching an agreement on its foundation. The main concern was preventing some countries from increasing their debt more than they could actually sustain only with their own public finances, just because they felt safe relying on the financial commitment of the other European partners. To avoid this misbehaviour, the ESM adopted precautionary and strict rules of intervention. The rules of intervention and the conditionalities attached to ESM programmes varies according to the type of support needed by the State in every specific case. We will deepen the analysis on the conditionalities directly analyzing the programmes of intervention of the ESM in a specific article (The ESM Programmes).
Therefore, the ESM has been created for sure to support the Euro Area countries during a financial crisis, but its role is also to defend the other Member States that are not directly affected from a possible contagion effect.
Hopefully the severe rules and conditionalities will be reduced in the future, increasing the solidarity among the States. However, this will be possible only proceeding on the path of European integration, because the unique way to reduce conditionalities is increasing the trust among Eurozone countries and to achieve it a major coordination is needed.
[1] https://en.wikipedia.org/wiki/European_Stability_Mechanism
[2] https://www.esm.europa.eu/
[3] https://www.esm.europa.eu/assistance/programme-database/interests-and-fees
[4] Maturity transformation. https://voxeu.org/article/make-sure-esm-s-pandemic-crisis-support-fit-purpose
[5] https://www.esm.europa.eu/sites/default/files/20150203_-_esm_treaty_-_en.pdf (Chapter 2 article 4)
