On Monday night, January 23rd, 2012, the Euro zone finance ministers reached an agreement on a contract for a permanent euro bail out fund – the European Stability Mechanism (ESM), which is worth 500 billion euro. The ESM is about to replace the European Financial Stability Facility on July 1st, 2012, one year earlier than originally planed.
The ESM will have a power to distinguish insolvent Euro zone governments from illiquid ones, when it makes loans. In a case of insolvent governments, a debt held by private bondholders, will have to be restructured to ensure that the governments’ debts are sustainable.
However, the Italian Prime Minister Mario Monti has indicated recently that he would like to see the ESM firepower to be doubled to 1 trillion euro. Mr Monti believes that the ESM worth 1 trillion euro would create confidence in the financial markets, which in return would lower the risk premiums on the Euro zone countries’ sovereign bonds.
At the moment, there is only one, effective way to lower the yields on the Euro zone countries’ sovereign bonds. It’s a trick use by the European Central Bank. In mid-December, 2011, the ECB decided to release nearly 500 billion euro in liquidity to banks within the Euro zone.
The banks borrowed money from the ECB at 1%. Then they bought the Euro zone countries’ sovereign bonds yielding 5% or higher; this brought down the yields. After that the banks deposited the bonds at the ECB as a security and borrowed even more money at 1%.
The money has been borrowed by over 500 banks for three years so far. There is a promise of more long term loans from the ECB to come.
However, the problem with this strategy is that: the yields on cash-strapped Euro zone countries’ sovereign bonds are still too high; the money has not been lent to companies within the Euro zone so as to get the economy going.
The crisis-stricken euro zone countries would like to see the ESM firepower to be increased, but only by larger contributions from the financially-healthy countries, such as Germany, Finland and the Netherlands. Italy and Spain, for example, don’t want to put more money into the ESM, because, as they say, the austerity measures they have recently implemanted leave them no room to manoeuvre (about Spain see globalopinion.pl ‘What challenges the Spanish Prime Minister Mariano Rajoy is facing?’ 22/01/2012).
The International Monetary Fund also wants the ESM firepower to be increased significantly. The IMF boss Christine Lagarde says that without a larger firewall, countries like Italy and Spain, which are now able to repay their debts, could be potentially forced into a solvency crisis by a high financing cost.
The French president Nicolas Sarkozy has said that Germany should be more generous and use its economic and financial power to assist the euro. The Belgian Prime Minister Elio Di Rupo has also signalled his desire to see the ESM firepower increased (Elio Di Rupo, a Socialist leader, was sworn in by King Albert II at the royal palace in December, 2011).
The other way to contain the Euro zone crisis is an introduction of jointly guarantee Euro bonds. Mr Monti is demanding an introduction of Euro bonds as a reward for tough austerity measures, Italy and other crisis-stricken Euro zone countries have already imposed.
In December, 2011, the Italian parliament approved a 30 billion euro package of austerity measures in a bid to shore up the country’s strained public finances. On January 20th, 2012, Mr Monti’s government approved a wide-raging package of liberalisation measures. The measures were designed to boost growth and heighten competition in a number of sectors. However, the Eurobonds idea is still strongly rejected by Germany.
The rumours are that Germany would agree to increase the ESM firepower up to 750 billion euro in return for accepting tougher budgetary rules, which are contained in a new fiscal compact.
A new fiscal compact is the EU’s latest attempt to bring the crisis to an end. It was drafted during the EU summit in Brussels, which took place on December 8th-9th, 2011. All the EU leaders, except the British Prime Minister David Cameron, agreed that it was the right way to contain the Euro zone crisis.
The fiscal compact says that the EU governments’ budgets must be balanced or in a surplus and that the annual structural deficit in a member state of the European Union cannot exceed 0.5% of nominal GDP. These rules must be introduced into the EU member states’ national legal system at a constitutional level or equivalent.
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