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ESM Threatens to Expose ‘Soft Core’

Better late than never. After a string of delays, and having overcome a constitutional obstacle in Germany, the euro zone’s new rescue fund, the European Stability Mechanism, looks set to be finally inaugurated on Monday.

European Central Bank
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European Central Bank

The ESM plays a vital role in European leaders’ efforts to tackle the euro zone debt crisis. However, the rescue fund will itself have to borrow any money it intends to disburse to countries in need of help.

Given that its predecessor, the European Financial Stability Facility, will for some time remain active in funding existing programs for Ireland, Portugal and Greece, the combination of two such large borrowers could make a splash in Europe’s bond markets.

Some countries and entities could face an unwelcome drenching. Increased ESM issuance is likely to have “an outsized impact” on government bond spreads in those countries in the euro zone “core” with weaker fiscal fundamentals, such as France, Belgium and Austria, according to a study by Goldman Sachs.

“The launch of the ESM could reveal hidden vulnerabilities,” says Natacha Valla, European economist at Goldman Sachs in Paris and the report’s author.

There are two main ways EFSF and ESM issuance could weigh on the government debt of the euro zone’s “soft core”.

First, the ESM could partly crowd out other European borrowers if investors view it as a better bet than the debt of some weaker continental borrowers. For example, the EFSF’s 10-year bonds offer higher potential returns than comparable bonds of Austria and France, and only slightly lower than worse-rated Belgium.

“There will be a substitution effect — investors will have the choice between the ESM and government debt,” Ms Valla says.

Second, although the ESM is structured so that its borrowings do not fall directly as liabilities on national governments, it will add to their indebtedness indirectly.

The burden on the fiscally healthy states will increase further if more countries enter a rescue program, points out John Stopford, head of fixed income at Investec Asset Management.

“There are some concerns over the ‘soft core’ countries like France and Belgium anyway, despite the recent rally, and more contingent liabilities could put pressure on their bonds,” he says.

Goldman estimates that an increase in Belgium’s ESM liabilities equivalent to 1 per cent of its gross domestic product would increase the country’s bond spreads by 25 basis points. If France saw a proportionately similar increase in its ESM liabilities, its spreads would widen by 10 basis points.

“Strong investor flows into some euro zone countries — I had France in particular in mind — have led to yields probably lower than economic and fiscal fundamentals would justify,” Ms Valla says.

Other analysts argue that substitution effects created by the ESM — by which investors would switch from, say, French or Belgian bonds into ESM debt — would be slow to feed through.

“In terms of displacement, it is years out,” says Steven Major, head of fixed income strategy at HSBC.

Others doubt that the ESM will have any meaningful impact on government bond yields. Carl Norrey, head of European rates trading at JPMorgan, says the EFSF has not crowded out government borrowing, and points to the fact that the ESM will not be included in any government bond indices.

These indices are influential. Money managers are generally averse to buying “off-benchmark” bonds — even if they represent a more enticing investment.

Rather, Mr Norrey and investors say the ESM is more likely to have an effect on other “supranational” borrowers on the continent, such as the EU or the European Investment Bank.

“The EFSF weighed on the other supranationals, and the ESM will probably do the same,” says Jozef Prokes, a portfolio manager at BlackRock. “But I don’t think either will crowd out France, or even Belgium.”

Still, investors and analysts say the ESM could have profound implications for European bond markets in the longer run — particularly if it proves a stepping stone towards debt mutualization across the euro zone.

Although this is something the German government has firmly resisted so far, “the ESM has got much more potential” than its predecessor, says Mr Major. In contrast to the EFSF, the ESM will have paid-in capital of €80bn, contributed in five tranches that are due during the next two years, and a legal structure akin to that of the European Investment Bank — which can borrow from the ECB.

“The officials have been clear that the ESM will not get a banking license, but there is still lots of speculation on access to ECB funding,” Mr Prokes notes.

Yet the biggest immediate impact of the ESM’s launch may have nothing to do with its lending programs. Markets are focused on when the ECB might launch its bond-buying plan to help countries such as Spain and Italy.

Mario Draghi, ECB president, has made the activation of its “outright monetary transactions” conditional on benefiting countries first agreeing an ESM support program.

“The most powerful impact of the ESM will be in activating the OMT,” says Andrew Bosomworth, a portfolio manager at Pimco in Munich.

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