Transforming the European Stability Mechanism (ESM) into a “European Monetary Fund” has come to dominate the debate on euro area reforms, albeit no one has actually proposed it to become “monetary”. Instead, in a recent interview, Germany’s chancellor Angela Merkel raised the idea of a short-term credit facility for member states hit by external shocks. Countries satisfying certain conditions could receive an ESM loan for maybe five years, with the loan size capped and repayable in full.
While hardly a leap forward for euro reform in the eyes of most, this augmentation of the ESM’s lending toolkit could be quite meaningful – if it is done right. By providing a stronger backstop against coordination failures in financial markets, it better guards against crisis. And by rewarding compliance with European rules and sound economic policies, it sets the right incentives.
Needless to say, an ill-designed instrument can be dangerous. If conditions for access to the credit line are watered down, the ESM may have to lend to member states that pursue inappropriate policies or pose a credit risk. At the same time, the ESM may find itself between a rock and a hard place if it has to fear that cutting the credit line may trigger a crisis. Too-easy terms may lead to overuse of the facility, so that the ESM becomes a regular source to satisfy member states’ financing needs. But also the opposite may occur – that no member state ever signs up for the facility, a fate that has already befallen some existing precautionary instruments.
This blog post outlines some principles for incentive-compliant lending instruments before delving into some of the details of the design of a precautionary credit line. This may serve to inform the debate that is likely to unfold in anticipation of the euro summit at the end of this month. However, fleshing out the details of a new instrument’s design will take much longer. Hence, this blog post can only provide a starting point for a deeper debate.
The power of ex-ante conditionality
The ESM is a crisis mechanism to prevent and resolve coordination failures in financial markets that can lead to a financial crisis. Sovereign debt crises typically start with a loss of access to market financing. Such losses of market access may arise from a sometimes irrational financial panic unrelated to a country’s long-run solvency or policies. For example, a country may be hit by contagion from crises elsewhere. In these cases, crisis lending by the ESM is clearly welfare-enhancing (Mussa et al., 2000; Jeanne et al., 2004).
In practice, crises are hardly ever unrelated to policies. Hence, it is important to consider the incentive effects of a financial safety net. Just as airbags in a car might induce less-careful driving, so a crisis mechanism may induce politicians to adopt unsound policies, or financial markets to continue to finance misconceived policies. Avoiding adverse incentives is even more important in the euro area, where member states retain substantial sovereignty in economic and fiscal policymaking.
Policy conditionality describes the set of fiscal and structural policies which are agreed with the member state and monitored by the crisis lender as a condition for providing a safety net. Conditionality can be applied ex ante, in the form of preventive policies, and ex post. Lending facilities using ex-ante conditionality are often referred to as precautionary credit lines.
While much attention is paid to ex-post conditionality – the policies agreed upon for crisis programmes – ex-ante conditionality offers a way to provide positive incentives for strong policies: Only member states continuously following sound economic policies receive access to a precautionary credit line on which they can draw when a (not self-inflicted) shock hits and financial markets go awry. Rather than correcting policies, the aim of ex-ante conditionality is to incentivise good policymaking. Since it is aimed at preventing crises, the ex-ante approach can improve welfare compared to a purely ex-post approach (Jeanne et al., 2001).
Generally, the situation of the euro area is well suited for a wider use of ex-ante conditionality. In many areas, common policies such as fiscal rules already bind national policymaking. Ex-ante conditionality can be fitted to common policies and provide an additional incentive for compliance. The ESM could build on this.
Getting the design right
Currently, the ESM offers two types of precautionary credit lines, the Precautionary Conditioned Credit Line (PCCL) and the Enhanced Conditions Credit Line (ECCL). To date, no member state has yet requested a credit line.
This mirrors the experience of the IMF, for which two key reasons have been identified. First, signing up to a precautionary facility is seen as sending a negative signal that a country believes it may become a victim of crisis. Second, while the idea is that a subscribing country is prequalified for emergency lending, access may be limited or additional conditionality may apply. This may induce policymakers to remain unconstrained by ex-ante conditionality, and negotiate conditionality only once in need of emergency lending (Enderlein and Haas, 2015).
These lessons highlight two important trade-offs to consider in the design of the credit line’s conditionality: between overuse and underuse, and between automatic access and case-specific access.
On one hand, member states should not rely on the credit line for normal funding needs or draw on it too frequently. This would transform the ESM from a crisis lender to a common financing instrument, which is not the idea of the proposal. Hence, strong institutional safeguards are needed to ensure the credit line is only drawn on under exceptional and unintended circumstances.
On the other hand, member states should not apply for the credit line only once they are at the verge of a crisis, as this would signal vulnerability and stigmatise the instrument. Instead of signalling a vulnerability, signing up for a credit line should be perceived as a stamp of approval for strong policies. As part of this, the analysis provided by the ESM in monitoring ex-ante conditionality adds to transparency and bolsters confidence of markets.
Moreover, member states satisfying the credit line’s ex-ante conditionality could be granted higher access, longer maturities, or lower interest rates under other ESM facilities. In other words, if more crisis funds are needed and the country decides to apply for other facilities (with ex-post conditionality), a more comprehensive backstop and more gradual adjustment could be offered given the country’s track record of strong policies. If markets reflect this more robust backstop in the pricing of government bonds, in particular at times of elevated risk, governments may be convinced of the credit line’s benefits and sign up in advance.
With regard to the second trade-off, the question is to what extent ex-ante conditionality follows an explicit “check list” or remains case-specific, and whether conditions can be adapted over time. The choice of criteria should be limited to those relevant for preventing economic crises, limiting their scope, and ensuring debt sustainability. Overloading the criteria with too many issues should be avoided, much like conditionality for crisis programmes (Tumpel-Gugerell, 2017; Wyplosz, 2017).
While there must remain scope to adjust the set of policy conditions, the credit line must remain credible in the sense that both member states and financial markets can trust the backstop. Otherwise, there is no advantage vis-à-vis the existing instruments with ex-post conditionality. However, compliance with a clearly defined set of rules – as in the proposal of a “discount window” by Enderlein and Haas (2015) – may be too automatic and too weak to protect the ESM from credit risk. Finding the right balance is an important detail that needs to be worked out.
Conditions of the credit line
The idea of a credit line is to offer bridge financing if a member state’s market access to issue sovereign bonds is inhibited for a short period. The facility does not replace other ESM facilities, in particular macroeconomic adjustment programmes to overcome deeper-rooted problems. If the credit line is drawn down and market access remains lost, the member state can still choose a macroeconomic adjustment programme.
Maximum access under the credit line should therefore be limited, for instance to one year’s gross financing needs. The total gross public funding need for all euro area member states amounts to about €1 trillion during one year. This exceeds the ESM’s current lending capacity of €500 billion. However, not all member states would draw at the same time, and not all countries would qualify for the credit line.
The Bagehot principle postulates that crisis lending is temporary and should take place at high lending rates to reduce reliance on crisis lending. Over the course of the euro-area crisis, the Bagehot approach for macroeconomic adjustment programmes was replaced by one in which solvency support through lower lending rates and management of debt-related cash flows dominated (Wyplosz, 2017). However, for a precautionary credit line, there is no reason not to apply Bagehot’s principle, at least in a tiered manner. Given its nature as bridge financing, interest for larger amounts drawn under the credit line could include a sizeable margin over the ESM’s cost of funding to discourage overuse. In the short run, the solvency implications for member states would be manageable. There is no doubt that the loan would need to be repaid in full, as the facility is not a transfer mechanism.
Precautionary credit lines are usually granted for a limited time, such as one year, and can sometimes be renewed. As opposed to the current ESM precautionary instruments, a facility as described here should be repeatedly renewable. A requirement to reapply for the facility annually (rather than an automatic extension) could reduce political pressure to soften ex-ante conditionality and overcome the challenge of withdrawing access to the credit line during difficult times. Besides the annual check-up before the ESM’s top decision-making body takes a decision on approving the credit line, continuous monitoring would ascertain whether any policies are being implemented that could severely alter the qualification assessment.
A precautionary credit line could be a small but meaningful addition to the ESM’s lending toolkit which looks fairly easy to implement. Such an instrument enhances the ESM’s credibility as a backstop in a sovereign debt crisis and delivers a more substantial contribution to euro area financial stability than changing the ESM’s legal statute, a questionable focus of the ongoing discussion.
However, the devil is in the details that can make or break the credit line’s success. A facility subject to ex-ante conditionality suits the current framework of common policies well, and could strengthen incentives to comply with good policies. However, a clever design needs to be found to navigate the difficult trade-off between overuse and underuse. While sufficient assurance for crisis assistance must be provided to member states signing up to the credit line, the ESM must be protected from pressure to water down ex-ante conditionality, and must be enabled to curtail or suspend access when policies deteriorate.