Moody’s downgraded the ESM (European Stability Mechanism) and the EFSF (European Financial Stability Facility) last week, reflecting the deteriorating creditworthiness of the Eurozone Member State guarantors of the main Eurozone bailout mechanisms. The European Community and the European Investment Bank were not downgraded, however. This development represents a realisation of the dangers of the UK’s further entanglement, where the ongoing deterioration in the finances of Eurozone states causes increasing dependence on the backing of the few remaining AAA-rated EU Member States, Eurozone or not.
The major player that is AAA-rated but outside the Eurozone is the UK.
The ESM was established in September but has not yet been “mobilised” i.e. drawn upon. The EFSF, by contrast, holds about EUR60bn of Greek government bonds and has issued a substantial volume of bonds to finance itself: the bonds so issued can easily be novated onto the name of the ESM – because the ESM legal structure is identical and its bonds are of exactly the same quality as those of the EFSF.
As well as replacing the EFSF, the ESM is supposed to take out the UK’s exposure (established via the European Community borrowing mechanism in 2010) on the European Financial Stabilisation Mechanism (EFSM). The debts incurred by the European Community to fund the EFSM cannot, however, be novated onto the ESM because the EC’s debts are better rated. The ESM would have to issue new debts itself to repay the EC and take over the EFSM’s loans (to Ireland and Portugal).
There have now to be serious questions about whether the UK’s liability really will be subsumed into the ESM in this way, at the point where the metal hits the meat.
Firstly, the combined loans of the EFSF now, plus what might be drawn in the coming months, plus the outstandings under the EFSM, will come close to the total of the ESM’s firepower. If that is the case, there will then be pressure to keep the EFSM going so as to retain headroom within the ESM to meet future needs.
Secondly, the EFSF may in the meantime experience a substantial firepower reduction if it has a write-off of part of its loans to Greece, reducing its assets but not its liabilities. Someone has to take another bath over Greece, and if it isn’t the EFSF and other “public creditors” that take it, they will have to force a second write-off onto private creditors. That move has already been termed a “betrayal”; it risks undermining the market’s trust in the Eurozone public authorities and consequently reducing the size of the market for the bonds of the ESM/EFSF – which reduces the firepower. The write-off has to come from somewhere and both options reduce the firepower available for wider Eurozone needs.
The upshot is that there is now a clear parting of the ways in the capital markets between the ratings of the three categories of borrower:
1. European Community – joint and several guarantee of all EU member states, with no percentages allocated as ceilings
2. European Investment Bank – guarantees of all EU member states, but with percentages allocated as ceilings
3. ESM and EFSF - guarantees of Eurozone member states only, and with percentages allocated as ceilings
The first consequence of the downgrade of ESM and EFSF further mobilisation of the European Investment Bank, increasing the risk attached to the UK’s contingent liability as guarantor on EIB, even if there is no further cash call.
But the bigger danger is that the downgrade derives from the increased the costs-of-borrowing for Member States through the ESM/EFSF compared to the EFSM, as well as the restriction on the amount of money that can be raised and its maturity. The temptation for the EU public authorities is obvious:
• The undrawn portion of the EFSM will now be drawn, rather than the EFSF being drawn
• There will be renewed discussion about how to use the other borrowing scheme through the European Community – the Balance of Payments Facility – for the Eurozone’s needs; the BoP Facility is supposed to be reserved for countries that are on the convergence path to the EUR, but ways of drawing it have been studied before… and any outstanding under the BoP will NOT be subsumed into the ESM
• It won’t be possible, when it comes to it, to subsume the EFSM outstandings into the ESM, because the market won’t take that much ESM debt to refinance it through a lower credit risk
• The total of EUR110 billion of borrowing facilities through the European Community – on which the UK’s risk is the whole lot – is the “bank of last resort” for the EUR
• Since the EUR is in the last chance saloon, that bank of last resort’s ATM is the one next to the bar
• To continue the analogy, the European authorities have appointed themselves as the card switching network behind the ATM – and they can allocate all debits back to the UK’s credit card
The authority to debit the UK’s card can be given under the Qualified Majority Voting system that is used in the Council of Ministers, thanks to the Lisbon Treaty. The UK has no automatic right of veto, because the borrowings, once created, must be met from the EU Budget. The UK would have the right to veto the EU Budget if it included the same amount as upfront funding of Member State requirements (e.g. through the Common Agricultural Policy). But creating a contingent liability on Member States through a separate fund sidesteps the veto. A deficit in the fund (caused by losses on loans to Member States) is then debited to the EU Budget over and above any approved annual Budget, and a Budget Deficit is underwritten by the Member States jointly and severally. Whereas the normal annual budget – payable in advance – is subject to percentages allocated as ceilings, the responsibility to cover a Budget Deficit is not.
Since the issue of the UK’s exposure to the Eurozone crisis was first raised in the first half of 2012, the UK government has done nothing to reinforce the flood defences: in fact it has met a EUR1 billion capital call from the EIB. Are they asleep at the sluice gates?
Bob Lyddon, General Secretary, IBOS Association
IBOS stands for International Banking - One Solution. It is an association which fosters inter-bank cooperation. Currently active in 27 countries and rapidly expanding, its members include Santander, HSBC France, Intesa SanPaolo, KBC, Nordea and UniCredit Bank.