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The European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM)
The dis-
cussions over the Greek bailout and the expectation that more would be needed led European finance
ministers to establish the European Financial Stability Fund (EFSF) in May 2010 to provide support for
countries that faced default. The EFSF raised funds by issuing bonds and other financial instruments
through capital markets. The money raised is lent to countries seeking assistance on the understanding
that reforms are put in place. The sum of
€750 billion was initially identified as needing to be raised. The
initial bailout of Greece accounted for
€110 billion of these funds; Ireland’s €85 billion and Portugal around
€80 billion. The establishment of the EFSF may have resolved some of the more immediate problems
that existed in 2010 but merely led to the markets turning their attention to other states deemed to be in
danger of default, notably Spain and Italy.
The situation in Italy was of significance because it accounted for a much larger proportion of total EU
GDP than Greece. If Italy were to default the consequences for the euro area and the global economy
would be dire. This is because Italy is the third largest economy in Europe but has a public debt reported
at
€1.9 trillion (about five times that of Greece). Between 2011 and 2014, Italy had obligations to redeem
around
€656 billion in debt. With interest rates on Italian debt at around 6.75 per cent, the cost of servicing
this size of debt in a period of economic slump places huge pressure on the government. If interest rates
rose by a further 1 per cent, it has been estimated that it would cost Italy a further
€38 billion over three
years,
€78 billion over five years and €313 billion over the life of the debt it has. It might be forced to borrow
even more to help service its debt.
In October 2012, the inauguration of the ESM meant that it assumed the tasks of the European Financial
Stability Facility (EFSF) and the European Financial Stabilization Mechanism (EFSM). Although the Treaty
was signed by the then 17 euro area countries, the ESM will also be open to non-euro area EU countries
for ad hoc participation in financial assistance operations. Based in Luxembourg, the ESM is meant to
provide a ‘permanent crisis resolution mechanism’. The ESM is classed as an intergovernmental organiz-
ation with a subscribed capital of
€700 billion. The 18 members of the euro area are the shareholders and
its lending capacity is around
€500 billion. Like the EFSF, the ESM will raise funds on the capital markets
CHAPTER 37 THE FINANCIAL CRISIS AND SOVEREIGN DEBT 797
and will work with the IMF in dealing with member states who request assistance. The ESM is expec-
ted to be part of the solution to member states’ problems and will operate in conjunction with the fiscal
compact in addressing the fiscal and structural problems facing member states. The ESM will only provide
support if the member state seeking help agrees to implement fiscal adjustment and structural reform.
Structural reform refers to changes in the labour and capital markets which are designed to help improve
the efficiency of the economy. One of the elements of ESM support is a consideration of the situation of
the member country and the overall stability of the euro area. If it is considered that the financial stability
of the euro area is under threat then the ESM can provide support.
Bailout funds have been used, in part, to help support the banking sectors in each country and help
banks recapitalize. Domestic banks, however, typically hold relatively high levels of sovereign debt, if the
country is in danger of default then this further weakens the banks’ position. Because these countries are
part of the single currency and as we have seen, wholesale financial markets are more integrated, the risk
of any single country defaulting leading to contagion in other European countries has been a key element
of the sovereign debt crisis.
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