ESM: a trap or an opportunity?

The second wave of the COVID-19 pandemic is stronger than anyone would have imagined. Our hospitals are suffering. Now more than ever, it is clear we need to invest heavily in our healthcare systems to improve their resilience and their capacity to endure emergencies like the one we are experiencing now.

There is a great deal of chance you have been hearing about the European Stability Mechanism, and about all sorts of reasons why countries should stay as far away from it as possible.

In this article, I will try to refute the allegations weighing on it and explain why it is a powerful instrument to help our healthcare systems weakened by the pandemic.

What is the ESM?

The European Stability Mechanism (ESM) is a European institution born in 2012. Its primary statutory purpose, as established by its founding Treaty, is to provide emergency aid to those countries facing temporary financial distress and unable to finance themselves on traditional markets. All 19 Euro Area Member States (EAMSs) are members of this institution.

The Pandemic Crisis Support

After being employed during the 2011 sovereign debt crisis, ESM assistance now plays a crucial role as part of a comprehensive plan designed by the European institutions to address the Covid-19 crisis.

Specifically, in April 2020, in the middle of the first wave of the COVID-19 pandemic, the Eurogroup agreed on creating a new instrument based on the ESM aimed at helping EAMSs finance healthcare-related expenses related to the pandemic, called “Pandemic Crisis Support” (PCS).

The PCS allows any EAMS to request, by the end of 2022, credit lines that will be set up with standardized terms and made available in as little as 2 months, for a maximum amount of 2% of the country’s 2019 GDP. They will have a maturity (repayment period) of up to 10 years.

PCS credit lines are particularly advantageous primarily because ESM enjoys the highest credit rating (AAA) and is thus able to finance itself on the market at very low, even negative, interest rates. These rates, as agreed by the Council, are then passed on to the EAMS with some fees, although lower than those that are usually charged.

In the graph below you can see the current interest rates required by investors to loan funds to each of the 19 euro-area governments for 10 years, together with the current estimated ESM/PCS rate when all fees are taken into account.

If you are discouraged by seeing all these numbers, bear with me for a moment while we undergo a concrete simulation to understand how the PCS can help.

Let’s take Italy as an example. Let’s assume Italy would like to raise debt to finance its hospitals for €35.8 billion (roughly 2% of its GDP), with a payback time of 10 years. At current rates, by financing itself on the market, after 10 years Italy would have to pay back €38.5 billion (the original €35.8 billion plus €2.7 billion in interest). If, instead, Italy financed itself through the PCS, after 10 years it would have to pay back only €34.9 billion, less than the amount originally borrowed! The PCS thus guarantees a total saving of €3.6 billion over 10 years compared to the self-financing option.

You can clearly see the advantage for countries currently paying positive interest on their debt (Greece, Italy, Cyprus, Malta, Spain, Lithuania, Portugal): they not only would not have to pay any interest on the amount borrowed, but they would actually get paid from investors to borrow money from them!

Still, even countries with a negative interest rate but higher than the PCS’ one (Estonia, Slovenia, Ireland, Latvia) would benefit from these special credit lines, as they would be able to pay back even less of the amount borrowed than what they would on the market.

Here below you can find a table with estimates on how much each country would be able to save over 10 years using PCS compared to the self-financing option, assuming they decide to borrow the maximum amount and fix a maturity of 10 years.

Countries on the graph that are on the right of the ESM, instead, would not benefit from ESM support as they can already finance themselves on the market at lower rates.

An additional benefit of PCS is that, even if a country applies for a credit line, funds do not necessarily have to be drawn because credit lines are designed to be a protection or insurance. What’s the harm in having this additional safeguard at one’s disposal?

Addressing common concerns

You may ask yourself: “if the ESM/PCS is so great and would help us save money and strengthen our national healthcare system, then why has no country requested it?”.

There are several reasons why, and they pertain to politics (should I say populism?) and to some (wrong) economic assumptions. Let’s review them together.

Conditionality

The first and most serious false concern is one starting from a true premise.

The argument is that European Treaties mandate that ESM support shall be granted only upon compliance with strict conditionality. This conditionality would have the consequence of strong mandatory fiscal cuts and/or tax increases for the country requesting a loan and possibly the loss of fiscal authority altogether in favor of European institutions.

It is true that, ordinarily, countries have to implement macroeconomic adjustment plans in exchange for ESM intervention, and rightfully so, as this instrument was born to deal with asymmetric financial crises, that is crises affecting only (or disproportionately more) one or a few countries. Since asymmetric crises mostly occur because of affected countries’ high public debt and ultimately result in the loss of market access, it makes sense to require these countries to undertake plans to get back on the trajectory to financial autonomy. However, this is not the case for PCS.

Since the nature of the pandemic shock is completely different (it is symmetric), the Eurogroup has decided that the only conditionality requirement would be in the use of the resources. These must be deployed to cover expenditures related to “direct and indirect healthcare, cure and prevention related costs” due to the Covid-19 crisis.

This general wording may, indeed, appear to conflict with Art. 136 of the Treaty on the Function of the European Union, which requires “strict conditionality” for ESM intervention. Still, Art. 12 of the Treaty Establishing the ESM allows room for discretionary interpretation in drafting the agreement with countries requesting help. A precedent in this regard is Spain, which was not required to implement macroeconomic adjustment plans after being granted ESM support in 2012.

Another fear is that, according to Art. 2(3) of Reg. 472/2013, when an EAMS receives financial assistance from the ESM on a precautionary basis, it is subjected by the Commission to enhanced surveillance. In practice, the country will undertake closer monitoring of its fiscal accounts, and review missions to verify progress made in addressing fiscal sustainability. Based on these reviews, the EU Council is entitled to recommend corrective measures or a macroeconomic adjustment plan, which are not, however, binding.

This is a potential downside of ESM credit lines, insofar as the procedure could cast doubts about a country’s financial soundness, exacerbating the traditional “stigma” attached to financial aid requests, and ultimately increasing funding costs.

However, Art. 2 also states that the Commission may “unilaterally” decide to subject any EAMS to enhanced surveillance at any point in time, regardless of whether they have requested and received ESM support, should it judge them at risk of fiscal unsustainability. This argument, therefore, does not hold.

Secondly, the cost associated with the negative stigma may become negligible if more than one EAMS requested assistance, signaling that its use is not linked to country-specific financial distress.

This is one of the main reasons no country has yet asked the ESM support: no one wants to be the first and risk that no other country decides to join, fearing the stigma.

Actually, however, it can be argued that markets will penalize those countries not exploiting ESM support, as this is not the rational option: investors regard favorably any action undertaken to reduce public spending, as this increases the probability that there will be enough money to pay them back.

Preferred creditor status

Another criticism concerns the “preferred creditor status” of ESM loans.

Unless this right is waived (as in the 2012 Spanish program), ESM loans are, indeed, senior over a defaulting country’s most other creditors, which means that the country in distress must pay back ESM loans before other creditors are reimbursed.

Clearly, seniority may have undesired effects on sovereign bond markets, as it increases risks of insolvency towards junior creditors and must be taken into consideration as a downside of ESM credit. However, given the limited PCS size, it’s unlikely it will turn out to be an issue even for highly indebted countries.

Political costs

A last consideration concerns political costs. Even if some countries may find it financially favorable to request support, large shares of the public are still hostile towards the ESM. Memories of the harshness suffered by the Greek people are still vivid and many governments, already under pressure by the crisis, may decide to forgo marginal savings in exchange for electoral survival.

Conclusion

We have seen how the Pandemic Crisis Support is a powerful instrument to finance direct and indirect healthcare costs due to Covid-19: it guarantees an adequate sum, a long repayment period, very low interest rates and it will benefit for sure 11 out of 19 euro-area countries. We reviewed the reasons why the criticism around it is mostly baseless.

Now, do we absolutely need it? No. Luckily enough for highly indebted countries, the European Central Bank is financing most of the public deficits needed to handle the consequences of the pandemic, thus relieving governments from the pressure on interest rates.

But if we can strengthen our healthcare systems and save some money, why not do it?