Euro Macro: ESM, ECB and own issuance likely to be the trio to fund governments – In yesterday’s daily we set out the numbers behind the eurozone government packages announced so far to fight the coronavirus economic shock. A big issue in play over the last few days is how these packages will be funded while keeping bond yields low, especially for Italy. The ESM looks ready to play a role, which would also  give the ECB the ability to launch the OMT, over and above the APP and PEPP programmes. Many governments that can will likely fund their programmes via own issuance. Meanwhile, it does not look likely that we will see a one-time issuance of Eurobonds, given the opposition of the Dutch and German governments.

ESM ready to finance eurozone fiscal stimulus –  Following the decision by the European finance ministers to scale-up the size of the discretionary fiscal stimulus in each of the individual member states to around 2% of GDP, the European Stability Mechanism (ESM) announced that it stands ready to finance a sizeable part of this stimulus. In a press statement, the ESM announced that it has an available lending capacity of €410 billion, which is equal to 3.4% of eurozone GDP. The ESM mentioned that the funds made available could amount to up to 2% of any country’s GDP, but that ‘this could be adjusted up possibly in view of the severity of the spreading of the coronavirus and its economic impact’. According to the ESM, the precautionary credit line ECCL (Enhanced Conditions Credit Line) would be the most suitable instrument to respond to the corona challenge. According to the rules of the ESM, the ECCL is available for countries whose ‘economic and financial situation remains sound’ but does not meet certain strict criteria related to, for instance, public debt, external position or market access on reasonable terms.

ESM conditionality, rules and costs If a country were to take-up an ECCL – The rules of the ESM state that the country will be subject to ‘enhanced surveillance’ by the EC, which covers the country’s financial condition and its financial system. Still, it seems that this surveillance will be less strict this time, as the statement by the ESM mentions that ‘the funds would be used to finance the country’s immediate health care and economic responses to the crisis, and that will also be the focus of our conditions’. It is up to the individual member states to decide whether to use ESM money or not. In theory they could also fund the existing fiscal stimulus plans themselves and use the ESM money to expand the total fiscal stimulus to 4%.

The main advantage for many member states of using ESM funds (assuming the country still has access to the capital market) is that it reduces the government’s interest payments compared to when it raises the money in the market itself. The ESM has a capital base of around EUR 80bn, which is paid by the individual member states. It raises the funds for its lending programme’s in the capital market and has been rated AAA by the main rating agencies. Bonds issued by the ESM are guaranteed by all member states weighted by their capital key, so de facto they are commonly issued bonds, but they also raise the debt repayment obligations of the individual member states. When a country uses a credit line, the ESM charges a weighted average interest rate, which covers the cost of funding and fees and margins charged for the assistance under each loan. The ESM has calculated the total reduction in interest payments for the countries that have received financial support during the eurozone crisis. These are, for instance, 7% GDP for Greece, 1.9% for Cyprus and 0.7% for Portugal. This time around, the advantage for, for instance, Italy could also be significant. Based on current funding costs and assuming that Italy would use the ECCL to the amount of 2% of its GDP (i.e. around EUR 36bn) the interest payment advantage could be around EUR 200 million. However, if Italy’s interest rate spread over Germany were to rise to the levels of the eurozone crisis, this advantage could rise to around EUR 1.5bn, or even higher.

Unlocking the OMT supplemented by ESM purchases – Another advantage of  making use of an ESM programme is that it allows the ECB to launch the OMT. A key condition for the ECB to buy a country’s bonds under the OMT is that it is in either a full ESM macroeconomic adjustment programme or a precautionary programme (such as the ECCL). An advantage of the OMT relative to the current QE programmes is that the ECB would not have to adhere to the capital key and that there is ‘no ex ante quantitative limits’. However, the ECB would still need to adhere to the issue(r) limit (though these can be raised). In addition, the OMT has a couple of limiting factors. First of all, transactions are focused on only 1-3 year bonds and the liquidity created through the OMT will be fully sterilised. Having said that, these modalities could be changed. In addition, we could see a ‘multi-tool’ approach. The OMT could work side-by-side with the APP, the PEPP, but also potentially with ESM bond purchases. Taken together, this would provide a significant amount of firepower, especially given that the PEPP – which is still the most powerful tool in the ECB’s armoury – could be increased further. (Aline Schuiling, Nick Kounis & Jolien van den Ende)