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ESM: what is the European bailout fund?

September 28, 2023

6 min

ESM: what is the European bailout fund?

What is the ESM? The meaning of the acronym is that of the European Stability Mechanism, but you can hear it referred to as the European bailout fund, an expression that briefly describes its function. Some additional clarification, however, is in order.

What the ESM is and how it works

So what is the meaning of the ESM? First of all, it is an international organisation formed in 2012 that focuses on the financial stability of the eurozone. To this end, it established a fund, consisting of contributions from various member states, which provides loans at favourable rates in the event of financial crises in the member states. The existence of such a fund is in the interest of all countries, not only to protect themselves against unforeseen events, but also because the crisis of one member can infect the economies of others within the community.

It replaces the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM), created to rescue Portugal and Ireland from the 2010 financial crisis.

Greece, Spain, Portugal, Ireland and Cyprus have already received assistance from this fund, through loans supported by a macroeconomic adjustment programme. In addition to this type of loan, there are other measures to be used on a case-by-case basis:

  • Primary market purchases
  • Secondary market purchases
  • Precautionary credit line
  • Loans for indirect bank recapitalisation (already used by Spain)
  • Direct recapitalisation of institutions

Access to this aid is conditioned by different, more or less stringent requirements. The formula with the most stringent conditions is the macroeconomic adjustment programme, which also imposes severe interventions on the financed country’s economic system.

EU bodies are extensively involved in the application and funding process, which follows these basic steps:

  • The state in difficulty applies to the ESM for assistance;
  • On behalf of the ESM, the European Commission ascertains whether the crisis in that particular state could have a contagion effect and defines the financial needs of that country;
  • The European Commission and the ECB negotiate with the state until a first agreement, the Memorandum of Understanding, is reached:
  • The ESM votes on whether to guarantee assistance.

Let us now see what the ESM is, or rather what it means in terms of governance, and what its decision-making structure is.

Who governs the ESM?

There are 20 EU member states in the ESM and they are all participants in the fund. The last country to join was Croatia in March 2023.

The organs of the ESM are the Board of Governors, composed of the 20 euro area finance ministers, which takes the main decisions unanimously, and the Board of Directors. The Managing Director is appointed by the Board of Governors for a renewable term of 5 years. The Managing Director of the ESM is currently the former Luxembourg Finance Minister, Pierre Gramegna. With the assistance of the Board of Directors, he is responsible for managing the fund’s assets.

Italy, the third partner after Germany and France, has subscribed to a share of 125.1 billion, of which it has already paid over 14.3 billion. The voting power, then, depends on the entity of the share, which for these three states exceeds 15%: they have the power of veto on emergency decisions requiring only an 85% majority (and not unanimity as is the norm).

But something is changing: what is the ESM reform and what does it mean for Europe?

The 2021 reform: what’s going to change?

The emergence of the pandemic in 2020 has highlighted the limitations of the ESM, which is not sufficient in cases of economic depression or major emergencies.

For example, in the event of temporary difficulties by a state with a strong economy, such as Germany, the functioning of the fund would require the contribution of smaller and more fragile states, aggravating the situation in the Eurozone.

With the 2021 reform of the Mes Treaty, which was initially voted in the Council in Brussels, the conditions for financial assistance would be strengthened and structured. The core of the reform, however, is to give the ESM the task of providing a financial safety net (backstop) as part of the banking crisis management system. Among other things, it envisages that the ESM can act as a mediator between states and private investors in the event that a public debt restructuring is needed. In general, the reform aims to increase the effectiveness of the ESM in preventing and dealing with crises.

Despite this first sign of change, there are still debated and criticised aspects of the very nature of the ESM, such as the lack of a democratic set-up in an organisation of such importance and impact. Or the excessive interventionism of the body in cases of macroeconomic restructuring, which can impose aggressive and therefore potentially disruptive measures on the country concerned. 

In fact, the reform is stalled, because of the lack of ratification by Italy, which continues to take its time to decide. The reasons for this reluctance are linked to the complex and delicate relationship between Italy and the European Union, and to the Italian government’s fundamentally opposed position towards the ESM itself.

So what is the ESM for Italy and what does it mean? On the one hand, it is an opportunity for the country to have an influential voice in the resolution of European crises, given its broad participation; on the other hand, the current government’s leadership, by focusing on the critical aspects, could distance Italy from the fund and the European system itself.