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Eurozone to launch new rescue fund ESM

October 8, 2012 Deutsche Welle
With the first session of the governing body, the eurozone's finance ministers inaugurate the permanent rescue fund ESM in Luxemburg. How does the new firewall against the mountain of debt work?

Even after it officially opens on Monday, there won't be much to see at the offices of the European Stability Mechanism (ESM). Despite soon being responsible for 700 billion euros ($912 billion), press spokesman Wolfgang Proissl told DW there may not even be a sign announcing the European bailout fund on the front of the inconspicuous office building where it is subletting space from the European Financial Stability Facility (EFSF), the eurozone's temporary rescue fund.

The 40 EFSF staff members are tasked with setting up the ESM. By next summer - at the latest - the permanent fund ESM will have become operational as an independent European institution that is in charge of the rescue activities for ailing euro zone countries. Germany's Klaus Regling, who currently heads the EFSF, will become the managing director of the ESM and will continue his pioneering work.

"We've prepared everything so that the ESM can start its work as the permanent stability mechanism for the euro zone on the very first day of its existence," Regling said at a press conference. "There will be a smooth transition from one to the other institution."

Eventually, 100 staff members will raise the money needed to rescue ailing euro countries and ailing banks.

ESM can lend 500 billion euros

The 17 eurozone member states pay 80 billion euros of capital contributions in cash into the ESM. An additional 620 billion euros will be promised as guarantees. On the basis of these pledges, the ESM will continue to do what the temporary rescue fund EFSF has done so far - sell bonds on the international capital markets. The ESM will lend the money to countries in need.

"We've also started marketing the ESM to investors all over the world. Investors are learning about the ESM as a new market participant," said Regling.

In order for the system to work, the ESM needs investors to buy its bonds. But of the 700 billion euros in its coffers, a maximum of 500 billion will effectively be given out. The rest will be retained in the form of so-called "excessive assurance," with the aim of demonstrating to investors that the ESM would be able to pay back its bonds if necessary. Germany, as the eurozone's largest economy, contributes some 27 percent of the capital, followed by France and Italy.

German approval required for more money

German Finance Minister Wolfgang Schäuble, who is also the country's representative on the ESM's board of governors, put the number of the theoretical financial risk on 27 percent of 700 billion euros, amounting to some 190 billion euros. The German Parliament approved this sum. Germany's highest court, the Constitutional Court in Karlsruhe, made a reference to the liability ceiling when approving the ESM laws.

Together with the eurozone's other 16 finance ministers, Schäuble will decide which country will receive how much financial aid and under which conditions. If necessary, the board of governors will be allowed to raise the capital. But Schäuble would have to ask the Bundestag for permission first.

In an interview with DW, the German finance minister expressed his relief at the fact that the Constitutional Court approved the ESM.

"The ESM does not violate Germany's Basic Law," Schäuble said. "It's good that the Constitutional Court did a thorough analysis because now the German population believes it, too."

At their last meeting in Cyprus in September, the eurozone's finance ministers confirmed their agreement that the ESM must make important decisions unanimously.

First client: Spain?

Spain is expected to be the first client of the permanent rescue fund. The government in Madrid has announced it intends to apply for 40 billion euros in aid to recapitalize ailing Spanish banks. In contrast to its predecessor, the EFSF, the ESM can support banks directly, which means that the loans will not be added to the sovereign debt of the bank's country of origin. In addition, the ESM has a banking license, which means it can raise money on the capital markets. The new rescue fund can also buy sovereign debt off the states. So far, this has only been possible on the secondary market, from banks and investors which for instance held Greek bonds that they wanted to get rid of. Cyprus has also filed a request for financial aid. But there are no details available as far as scope and conditions are concerned.

"ESM is a big bad bank"

In an interview with German television channel Phoenix, Hans-Werner Sinn, the head of Munich-based ifo Institute for Economic Research, warned this summer of exaggerated expectations regarding the ESM. The new fund, he said, would not constitute a solution to the causes of the debt crisis, but it would merely buy some time. The ESM would mainly benefit investors who wanted to get rid of their worthless bonds and heavy risks.

"Those who hold the papers now have an interest in getting out of the situation," said Sinn. "That's why they support plans to establish a big bad bank under the name of ESM in Luxemburg. What they want is a banking union and eventually a socialization of debt across Europe. They want the countries that are still strong today to shoulder the burden that the weak countries can no longer carry."

"ESM will be successful"

Regling, however, was less critical, "Looking at all the preparations, the structures of the ESM and its significant capital, I am confident that the ESM can be just as successful on the markets as the EFSF has been so far."

The EFSF has not registered any losses since it was set up in June 2010. It has placed 60 billion euros worth of bonds on the financial markets. It has the top rating AAA. But rating agency Moody's has warned of a possible devaluation with the explanation that a rescue fund can only be as good as its members. And Moody's said it is noticing a downward trend for the eurozone countries, who are the owners of the EFSF and ESM.

In June 2010, Regling said he assumed that the mere existence of the EFSF would be enough to calm down the financial markets. The fund would probably not even be used, he added at the time. Two years later, reality proved Regling wrong. Greece, Ireland and Portugal are dependent on the rescue fund. And Cyprus and Spain will probably also soon be filing detailed applications.