In the face of the EU debt crisis, the European Financial Stability Facility is one of a raft of reforms aimed at safeguarding the future of the eurozone.

In response to the sovereign debt crisis in Greece, the European Financial Stability Facility (EFSF) was created in May 2010 as part of the €750bn European financial safety net, with the objective of securing stability within the eurozone. This support package comprises three components. First is the European Financial Stabilisation Mechanism (EFSM), whose funds are available to all 27 members of the EU. It is administered directly by the European Commission and has a lending capacity of €60bn. Second is the EFSF, a Luxembourg-based company whose shareholders are the 16 member states of the eurozone. The EFSF has the capacity to provide financial assistance supported by guarantees of up to €440bn for on-lending to a eurozone member state. The third component is the International Monetary Fund (IMF), which has agreed to provide loans up to half the amount drawn from the EFSM and EFSF.

Within this framework, the EFSF's main task is to provide medium- to long-term financial assistance to countries whose access to financial markets has become seriously constrained. The decision to provide financial assistance is made once a eurozone country makes a formal request for assistance and the consequential support and adjustment programme has been negotiated in co-operation with the IMF and in liaison with the European Central Bank. Once the programme has been approved by the eurozone finance ministers (the Eurogroup), the EFSF would need about two weeks to raise the capital on the financial markets. From a request for assistance by a member state to the first disbursement of funds is expected to take about four weeks.

Liquidity and solvency

The purpose of the financial support is twofold - to provide immediate liquidity assistance at reasonable costs and to restore the long-term creditworthiness of the borrowing country, ensuring it regains access to the financial markets as soon as possible. This is secured by conditioning disbursements on fiscal and structural policies aimed at improving the economic fundamentals of the country.

The EFSF's ability to raise funds at reasonable costs from the financial markets and lend to the countries in difficulty is based on the irrevocable and unconditional guarantees provided by the eurozone member states. Funding and investment strategies of the EFSF have been designed to obtain the top rating of the financial markets. The credit enhancements include an over-guarantee of 120% against all the liabilities towards investors, a cash reserve and a loan-specific cash buffer to provide additional reassurance to potential investors. As a reflection of these enhancements, the EFSF has been assigned an AAA credit rating by Standard & Poor's and Fitch Ratings, and an Aaa rating by Moody's.

The interest rate charged to the country in question is based on the EFSF's own funding costs, the margin and the service fee, the latter two of which are paid upfront by the country. The EFSF's own funding costs depend on market conditions. Taking into account the EFSF's design and legal base and its credit enhancement strategies, its borrowing costs should be comparable to those of AAA rated governments.

Borrowing from the EFSF is subject to strict conditions, similar to the loans of the IMF. Before receiving EFSF financial assistance, the country commits to a stringent multi-year programme of tailor-made economic and fiscal adjustment. The conditions vary from country to country but normally include targets and ceilings on state spending and also structural reforms, such as modernising public administration, improving labour market performance and enhancing the tax systems, with the aim of increasing a country's competitiveness and growth potential.

The combination of reasonable borrowing costs and economic reforms enforced by strict conditionality of the EFSF loans form the cornerstone of the strategy of bringing the country in difficulty back onto a sustainable debt path and restoring its long-term creditworthiness.

Turning fiscal deficits into surpluses involves painful economic reforms as expenditures need to be cut and tax revenues increased. It is difficult to avoid short-term pain arising from these fiscal austerity measures, and this is one of the reasons why fiscal corrections are typically postponed. At the same time, however, one of the main aims of economic programmes must be to achieve permanent improvements in a country's fiscal balance. This will mitigate the short-term costs because long-term benefits of economic reforms will be anticipated by the markets and households.

Lending by the EFSF ensures that the interest payments on public debt do not become so unsustainably large with respect to a country's growth potential that the country is unable to fulfil its debt obligations during or after the implementation phase of the economic reforms.

From this perspective, financial assistance from the EFSF is also an instrument to bring forward and safeguard the success of economic reforms that may otherwise be economically and politically too costly to achieve. Whether EFSF funding is sufficient to avoid debt restructuring and enable the country to regain access to the financial markets thus crucially depends upon the country's own willingness to implement structural reforms and boost its growth potential. The same logic applies to lending from the EFSM and the IMF.

Unique euro characteristics

The basic principles for EFSM and EFSF lending are similar to the IMF model, drawing on its extensive experience. For Greece and Ireland, it has been a combined package using both EU and IMF support. However, the key difference compared to assistance to other nations is that eurozone countries are part of a shared currency and hence common monetary policy. Moreover, external debt in many European countries is high and the holding of this debt is concentrated within the eurozone financial institutions and domestic private investors. Due to the common currency and concentrated holdings of eurozone debt, even a threat of sovereign default in one country can cause difficulties to the eurozone banking sector and hence to the financial stability of Europe as a whole. The European sovereign debt crisis has indeed revealed the extreme sensitivity of the European financial markets to potential losses caused by sovereign debt defaults.

As for the EFSF's future, the EU finance ministers approved on November 28 the outlines of a new permanent mechanism for dealing with economic crises in the eurozone. From 2013, the European Stability Mechanism (ESM) will be capable of providing financial assistance to the eurozone member states in line with current EFSF principles. The ESM will complement the new framework of reinforced economic governance of Europe and focus on prevention of future crises. In particular, the ESM includes elements that are expected to increase market pressure for more prudential fiscal policies by making each country's financing costs more sensitive to its fiscal position. If necessary, private sector creditors will be involved in the crisis resolution in accordance with established IMF policies. One of the key elements of achieving this is to introduce collective action clauses for all new eurozone government bonds, which reduce the legal obstacles for debt restructuring.

Financial support and crisis resolution mechanisms are not the only elements of the recent decisions to address the problems that have accumulated during the first decade of the European Monetary Union (EMU) and which have become so visible during the crisis. Other elements consist of creating a new surveillance mechanism to prevent excessive imbalances, improving fiscal coordination within the Stability and Growth Pact, enhancing the European supervisory structure and strengthening capital requirements of financial institutions.

Europe has taken big steps in recent months to tackle the sovereign debt crisis in the eurozone and has shown it is serious about the functioning of the EMU and the protection of the euro. The EFSF and the commitment to create its successor, ESM, together with the other reforms to European governance will make sovereign debt crises less likely in the future and safeguard the financial stability in Europe.

Klaus Regling is CEO of the EFSF, and was previously the director-general of economic and financial affairs at the European Commission

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