Q&A: European Stability Mechanism

European Union flags Analysts are unsure as to whether the ESM will be enough to save the eurozone

The eurozone's new permanent bailout fund for struggling economies and banks has been formally launched.

It is one of the key elements in the eurozone's defences against a deepening debt crisis.

But what exactly is the European Stability Mechanism (ESM) and how will it work?

What is the ESM?

The European Stability Mechanism is a new European Union agency that will be able to provide financial assistance to eurozone countries in difficulty.

It is a permanent agency, based in Luxembourg, and will eventually replace the temporary European Financial Stability Facility (EFSF), although the two will operate in parallel for some time.

How much financial help can it provide?

The ESM will ultimately - from 2014 - be able to use up to 500bn euros ($650bn; £400bn) to help countries in difficulty. In the interim, the EFSF will be able to make up the difference so that the total capacity for new assistance will be 500bn euros.

How will the ESM get the money?

It will borrow in the financial markets, by selling bonds, the same method that governments use for most of their borrowing needs.

Is there a contribution from governments?

The financial foundation of the ESM is capital provided by the eurozone governments. They have committed a total of 700bn euros, although the plan for up to 2014 is that they will actually pay in just 80bn euros. The additional capital can be called in if it is needed.

The capital is NOT the money used for providing assistance. It absorbs any losses if countries receiving help fail to repay it. It provides a reassurance to investors in the financial markets that they can lend to the ESM (by buying its bonds) and be confident of being repaid.

Which countries are the biggest contributors?

Germany will provide 27% of the capital, France 20% and Italy 18%.

Anything from the UK?

No. The UK does, however, contribute to existing bailouts through the IMF. It also made a bilateral contribution in the case of the Republic of Ireland.

What form will the financial assistance to eurozone governments take?

The ESM will be able to lend directly to governments. It will also be able to buy their debts (bonds) either directly when they are first issued or in the financial markets.

In addition, the ESM will be able to support banks directly, but only once there is a new eurozone supervisory system in place involving the European Central Bank. This support would be "recapitalisation", or taking a shareholding.

Will there be conditions attached to financial assistance?

Yes. The economic policies will be negotiated on a case-by-case basis, but they are likely to include steps to reduce the borrowing needs of the country concerned - some combination of spending cuts and tax increases.

They are also likely to include reforms intended to stimulate economic growth, such as introducing more competition into the labour market and other areas of the economy.

Will it be enough?

The big question is what if Spain and Italy need assistance? They are much larger economies, with larger debts and larger annual borrowing needs than Greece, Portugal and Ireland.

One assessment estimated Italy and Spain's total financing needs in 2013 and 2014 at 670bn euros. That is more than would be available, so the ESM is not enough on its own to cover those two countries even for two years.

However, if they do seek assistance the European Central Bank would be ready to intervene by buying their bonds in the markets. The ECB's financial firepower is potentially unlimited. It is a central bank so it can simply create the money to buy as much as it chooses. The ECB has recently set out elements of a strategy for doing this.

Does the ECB's plan mean the ESM is unnecessary?

No. The ECB is only willing to take such action if the country concerned has sought help from the ESM and has agreed a programme of policies.

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