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Good for now

11 Jul 2012 By Neil Unmack

Last November, the euro zone crisis forced the European Financial Stability Facility to delay a bond deal. Now the crisis is back, but the bailout fund is holding up. It has just issued its largest public bond, paying just 1.652 percent for five-year money. That has eased concerns after a previous bond issue was not fully subscribed. However, bigger challenges lie ahead.

The EFSF will soon need to raise as much as 100 billion euros to recapitalise Spanish banks. If the crisis worsens, it may also need to provide financial aid to Italy and Spain too, either by buying those countries’ bonds, or by providing lines of credit.

It certainly helps that investors are currently desperate for any half-safe asset that offers a positive yield. Nevertheless, prospective bond buyers have two concerns. First, the EFSF’s funding needs could flood the market, depressing prices. And second, its credit quality will suffer as its guarantors – primarily Germany and France – increase their exposure to the periphery.

One way to avoid market indigestion is for the EFSF to issue bonds directly to Spanish banks, which can then use them as collateral when borrowing from the European Central Bank. The euro zone recently used that trick in Greece.

Europe has another weapon, the permanent bailout fund known as the European Stability Mechanism (ESM) should come on line soon, and will replace the EFSF. Rather than relying on promises of payment from its guarantors, the ESM will have 80 billion euros of hard capital, which should make it easier for the fund to borrow. Its preferred creditor status should also mean loans are safer, easing the strain on its guarantors’ creditworthiness.

The snag is that the ESM is constantly changing, as euro zone politicians are pressured into making bigger promises. Loans to Greece, Ireland, Portugal and Spain may rank alongside, not ahead of, other debt. The ESM may even end up owning stakes in banks, giving it a riskier and less liquid asset pool. And France and Italy would like the ESM to provide funds with fewer conditions. Investors who buy ESM debt may wonder what they will own in five years’ time. Europe’s bailout funds have yet to face their biggest test.


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