The European Stability Mechanism hangs by a thread – on France’s credit rating

Introduction

The European Stability Mechanism (ESM) backstops the euro. Its nominal size is €705 billion but its lending capacity is lower at €500 billion, and the main condition attached to that is that the member states guarantees of the ESM’s solvency must be good enough and big enough to convince credit rating agencies to assign the ESM a AAA rating, so that the ESM can raise the funds it wants to lend. The difference between the ESM’s nominal size and its lending capacity acknowledges that the guarantees of some member states are not good enough.

This structure is hanging by a thread. Standard & Poor’s Global Ratings attached a ‘Negative Outlook’ to France’s AA rating on 2^nd June 2023. If at any point France’s rating drops to AA-, the ESM’s roof falls in.

What is the ESM?

The ESM is now the Eurozone’s only significant bailout mechanism. €30 billion might be available out of the European Financial Stabilisation Mechanism (EFSM), but the European Financial Stability Facility (EFSF) is closed to further lending, with €191 billion of loans outstanding.

The ESM is the Eurozone’s alternative to having genuine central bank money. If a Eurozone member state is unable to pay its debts as they fall due, it cannot instruct its central bank to issue more currency, as a genuine sovereign with its own currency like the UK can do.

Instead the member state issues new debt that is bought by the ESM, and it uses the proceeds to pay the pre-existing debts it could not either service or refinance off its own bat.

The ESM currently has €86.2 billion lent out, to Spain (€20.1 billion), Cyprus (€6.3 billion) and Greece (€59.8 billion),¹ leaving €414 billion of supposed firepower.

Policy conditions driving the ESM’s ‘firepower’?

The current ESM operational constraints are relatively simple. The ESM’s paid-in capital is meant to be kept in high-quality liquid Investments. Moreover, the ESM’s loans should be funded from the issuance of bonds. This allows member states to guarantee the ESM’s debts rather than borrowing themselves to inject capital beyond the paid-in amount. This was the result as of 31/12/22:

ESM assets		ESM liabilities
Investments2	€101 billion	Paid-in capital	€81 billion
Bailout loans	€86 billion	Bonds issued	€102 billion
	€187 billion		€183 billion

The ESM’s balance sheet totals €813 billion, though, because it puts the entire €624 billion of member state guarantees as an asset on its balance sheet. These guarantees are in the form of callable capital.³ In consequence the ESM’s ‘Shareholders’ Equity’ is given as €705 billion: €81 billion of paid-in capital plus the €624 billion of callable capital.

Practical conditions driving the ESM’s ‘firepower’

The ESM’s firepower (or lending capacity) depends on its borrowing capacity, which depends on its credit rating, which depends on the credit ratings of member states. The ESM’s current rating is AAA, because enough large member states have high credit ratings themselves. The rating agencies ideally look through the ESM to member states with AAA ratings and substantial obligations to pay in new capital: Germany, Luxembourg and the Netherlands have signed up for €205 billion. That does it for the existing bonds of €102 billion, might do it for another €103 billion but wouldn’t do it for anything beyond that.

The agencies then look to member states with AA+ ratings, and then AA, and require there to be an increasing excess of guarantees over the amount of bonds for the ESM to retain its AAA rating. This is the concept of ‘over-guarantee’, as operates in the EFSF and is why the ESM’s size is 141% of its lending capacity. The guarantees of member states with ratings of AAA, AA+ and AA must exceed the amount of bonds in issue by a given quotient, in order for the ESM’s bonds still to be rated AAA.

France’s position is critical, because it is big with a callable capital of €126 billion, and it is on the edge of losing its AA rating and dropping out of the group of member states whose guarantees are good enough.

Member states whose guarantees are not good enough now

If the same AA rating criterion as the EFSF is used, the eligible callable capital shrinks away.⁴ This reduces the firepower, which is €82 billion lower than the eligible callable capital, because this capital needs also to cover the €102 billion of existing bonds net of the portion of them (around €20 billion) currently being held as Investments.⁵

The table below starts with the ESM’s own calculation of its firepower, and then presents three of our alternative calculations of it, based on the ‘Eligible callable capital’ after drop-outs, and the deduction of the further €82 billion as per the preceding paragraph:

Countries backed out of the Euro-20	Eligible callable capital	Firepower	Notes
None – the ESM’s calculation	€624 billion	€414 billion	€500 billion remains the lending ceiling, less €86 billion of loans outstanding
Greece, Cyprus, Italy, Portugal, Croatia, Malta, Spain, Latvia, Lithuania, Slovakia, Estonia, Slovenia	€390 billion	€308 billion	All rated below AA, and includes 4 of the 5 borrowers from the EFSM, EFSF and ESM
The above plus Ireland	€380 billion	€298 billion	A borrower under the EFSM and EFSF
The same group plus France but not Ireland	€264 billion	€182 billion	If France was downgraded to AA- from AA

The bottom line is that France’s callable capital is material and central to the ESM’s structure whereas Ireland’s is neither. If France’s callable capital is deemed unreliable, the ESM’s firepower drops off a cliff, to €182 billion.

The ESM cannot then discharge its purpose: providing debt relief to member states, regardless of their size. Put differently, a drop-out of France would bring the house down, exposing the circularity of this ‘auction of promises’ and the vacuum in the middle: the lack of genuine euro central bank money.