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29 April 2020

Vox: Maturity, seniority and size: Make sure the ESM’s pandemic crisis support is fit for purpose!

A discussion is playing out in European capitals, most intensely in Rome and Madrid, regarding the usefulness of tapping these credit lines.

Most of the discussion regarding access to European Stability Mechanism (ESM) financing to fight the Covid-19 crisis has focused on the importance of removing conditionality from ESM loans. Memories of harsh austerity and fears of an electoral backlash made it imperative that a detailed memorandum of understanding (MoU) was not part of ESM loans. Removing conditionality would not only eliminate the stigma that asking for help could create (already an important concern), it would also prevent the potential damage from ill-timed fiscal measures during a reconstruction process that is quite uncertain in all but one feature – it will be long and difficult. On 9 April, EU finance ministers agreed that the ESM can provide loans with the sole requirement to commit to use the money to pay for direct and indirect healthcare, cures, and crisis-related costs. This new dedicated facility will be called the Pandemic Crisis Support Credit Line (PCSCL).

However, while we know the PCSCL will not include thorough conditionality in the form of a MoU, there is much less clarity regarding what type of financing terms it will offer. According to officially disclosed information, the PCSCL will be based on the existing Enhanced Conditions Credit Line (ECCL). This implies that there are additional characteristics of the loans that are known:

Maximum size: The finance ministers have agreed that the ESM can grant PCSCLs amounting to 2% of each member’s GDP.  

Interest rate on the loan: The standard pricing of an ECCL, once it is activated, is 35 basis points (plus fees) over funding costs. To this, commitment fees for making the credit line available should be added.1

Type of access: ECCL credit lines have an availability of one year (renewable) and can be drawn via a standard loan or a primary market purchase.2

What is missing?

The following are financial aspects that would shape the impact of the PCSCL, but for which we still have no detail:

Funding strategy: In order to understand what the cost of the PCSCL will be, we need to know not only what margins and fees the ESM will charge, but also how the ESM is going to finance the loans.

What issuance strategy by the ESM should back PCSCL support? While ongoing debates have brought proposals for the issuance of perpetual bonds, as we argue in Erce et al. (2020), the most effective way to provide official support is to obtain financing using instruments that are as short as possible. In this way, the ESM can leverage the currently ultra-low short-term interest rates and perform a strong maturity transformation.

Loan maturities: According to the existing guidelines, there is no written limit to the maturity of the ECCL support. We know, however, that the amended ESM treaty, the discussion of which was frozen by the Covid crisis, wanted to impose a maximum average maturity of five years. In a recent interview, Klaus Regling argued that average maturities for the PCSCL could be as long as 10 years. In Erce et al. (2020), we show quantitatively the extent to which maturities longer than 10 years would help smooth refinancing needs in the medium term.

Seniority: The typical loan from the ESM is senior (its repayment has priority in default) to every creditor but the IMF, although ESM seniority can be waived (as in the 2012 Spanish programme). Will the ESM remain senior under the PCSC? Or will it, as the ECB, lend in a pari-passu fashion (i.e. be treated equally as the rest of creditors)?3

The risk to avoid: “Too senior not to disrupt”

During the euro area crisis, the seniority status of official lenders became an especially contentious issue. The senior role of the ESM replaced the de jure pari-passu approach initially pursued. The rationale for claiming seniority is that official support (both through liquidity and conditionality) increases a county’s ability to repay, to the benefit of all existing creditors. In exchange for ‘enlarging the size of the cake’, the ESM claims seniority (Corsetti et al. 2020). 

The seniority of ESM loans can have undesired effects on sovereign (junior) bond markets. According to Ghezzi (2012), the euro area experience proved that private sector subordination can have perverse effects when markets are not certain about the success of the programme.  If the sovereign borrower does not recover following official lending, the loss given default increases as the official loan dilutes private creditors. This can undermine market access.

On the ‘positive’ side, the small loan size proposed makes dilution less important. How important dilution is would depend on the repayment structure of the loan. A bullet repayment approach would imply an increase of refinancing needs of 2% of GDP the year the ESM loan would mature. 

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