The Italian parliament voted to delay the approval of the reform of European Stability Mechanism (ESM). Italy’s opposition appears to be largely based on populist-political mistrust towards the ESM rather than a thorough evaluation of Italy’s national interest. ESM treaty reform was agreed in 2021 and is principally aimed at strengthening the euro area’s ability to deal with the destabilizing consequences of banking sector crises. The reform requires approval by all nineteen euro area member parliaments. The main reforms include: (1) establishment of an ESM-funded financial backstop to the Single Resolution Fund (SRF), (2) reform of ESM governance, (3) changes of eligibility criteria for accessing precautionary financial assistance instruments, and (4) introduction of so-called single-limb collective action clauses in new sovereign bond issues. The Italian parliament (and government) seems to have reservations about several of the proposed changes, fearing that they might make it more likely that Italy could be forced into a debt restructuring, should it require access to future ESM financing.
The proposed reform would allow the ESM to lend funds to the Single Resolution Fund (SRF), which would enhance the euro area’s ability to deal with banking sector crises. (The SRF was established to resolve failing banks to safeguard euro area financial stability in the context of concerted attempts to strengthen banking union and indirectly monetary union.) This part of the reform package Italian parliamentarians will find least problematic, as it contributes to strengthening euro area governance and benefits in particular countries that have weaker finances and are at higher risk of banking sector distress. The SRF is financed by contributions from banks, not governments or taxpayers, and sits on €80 billion. The SRF covers the costs of providing financial support in the event of systemically important banks getting into trouble. ESM reform would allow the ESM to lend up to €68 billion to strengthen the SRF’s capacity to act as a financial backstop in the event of a major crisis. The ESM backstop is to be used as a last resort only, namely in a situation where SRF runs out of money and the Single Resolution Board (SRB), which controls the SFR, is unable to raise sufficient contributions or raise other financing. The reform will allow the ESM to act as a common backstop to the SRF in a way similar to the Federal Deposit Insurance Corporation (FDIC) having access to a credit line from the U.S. Treasury.
As far as ESM demands for a debt restructuring in the context of financial assistance programs are concerned, the proposed reform does not change anything. The ESM treaty has always allowed for such a possibility. The original ESM treaty calls for adequate and proportionate private sector involvement in such a scenario, meaning that a sovereign may be obliged to restructure its debt before being able to access ESM financing. But restructuring is meant to take place only in exceptional circumstances. The reform proposal does not contain any changes regarding debt restructuring, nor does it make debt restructuring automatic in the sense of making it a pre-condition for accessing ESM funds. It is true that the ESM may have a more prominent role in affecting the design of conditionality and macroeconomic adjustment due it being in charge of analyzing debt sustainability. This is critical because it affects whether or not a borrower may be required to restructure its debt before accessing funds. This appears to have some Italian lawmakers deeply concerned about the ESM demanding Italy restructure its debt in exchange for receiving financial assistance. In reality, however, the proposed governance changes do not present a meaningful change of ESM policy or power, as one way or the other the ESM, or rather its government shareholders, has to sign off on financing, conditionality, including demands for a debt restructuring.
The proposed reform also foresees changes regarding the ESM’s various financial assistance programs and the rules and conditions for accessing them, quite aside from “private sector involvement” (or debt restructuring). The changes only relate to precautionary programs though. As before, loans will continue to come with demands for macroeconomic adjustment. Precautionary financial assistance for countries with fundamentally sound fundamentals comes with far less stringent conditions attached. The reforms tighten slightly access to precautionary lines of credit, but they do not make any changes non-precautionary programs. The concern here seems to be that these rules may make it more difficult for Italy to access ESM financial support. But the rules change tighten access to pre-cautionary programs only very marginally, and it will not make a difference to a country experiencing significant financial distress, as it would have to request loans that come with macroeconomic adjustment requirements. And the reform foresees no change in this respect. Overall, the tightening of pre-cautionary access is understandably something debtor countries are not keen on, though the changes appear minor.
The reform also mandates the issuance of a new type of collective action clauses (CACs), which in the view of its Italian critics will increase the risk of a future Italian debt restructuring. The argument is that the introduction of less onerous collective action clauses may lead investors to demand higher yields and increase the risk of financial distress because it affords investors fewer legal protections. Specifically, the proposed reform foresees the introduction of so-called single-limb CACs, meaning that a qualified majority of debt holders suffices to restructure all debt, rather than require the government to win an overall majority as well as majorities at the level of each individual issue. However, it is far from obvious that the introduction of CAC will lead investors to expect higher default risk. When CAC’s were introduced in 2013, they did not impact Italian credit spreads meaningfully. Default risk is largely a function of macroeconomic conditions, not legal safeguards. Moreover, if the Italian government wanted to, it could simply impose a restructuring unilaterally, given that 99% of Italy’s debt consists of instruments issued under domestic law. In other worlds, investors in Italian debt already benefit (or suffer) from limited legal safeguards, in case the Italian government decides to restructure its debt by changing domestic law. If anything, single-limb CACs helps reduce uncertainty by limiting the power of hold-out investors that have the power to delay, even sink the restructuring in case a country is forced to restructure for economic-financial reasons.
Concerns about the negative effects of ESM reform on Italy’s economic and financial interests appear exaggerated. The reforms will not require an automatic debt restructuring, they do not significantly tighten access to financing and only do so in case of precautionary programs, and single-limb CAC’s are not likely to increase Italy’s default risk. The greater involvement of the ESM with respect to debt sustainability analysis may make it appear as if it has a greater say over lending and debt restructuring decisions as well as the design of macroeconomic adjustment. In reality, however, the reforms do not entrust the ESM with macroeconomic surveillance tasks, which it will share with the European Commission, nor does it change the ESM’s influence in the sense that the ESM continues to controlled by its shareholders (euro area members) that ultimately do or do not sign off on financing, conditionality or a request for debt restructuring. This suggests that Italian opposition is at least in part due to populist politics. The endorsement of the proposed reform by the Italian treasury, which expects the reform to improve Italy’s creditworthiness, and the Italian central bank also suggests as much. The ESM is deeply unpopular in Italy and it has been a political football ever since Italy. If this analysis is correct and the negative effects of the reform are limited (and parliamentarian are aware of that they are), it is quite possible that Italy will yet approve the reforms before the year-end deadline.
As far as the broader implications are concerned, ESM reform would represent a further (small) step towards addressing the inherent fragility of Economic and Monetary Union (EMU). Progress towards banking union has made little progress in the past few years due to disagreements between creditor and debtor countries, or countries that benefit from a strong financial position and countries whose financial position is potentially weak. Creating a backstop to the SRF will help strengthen the euro area’s ability to intervene more decisively during systemic banking sector crises by providing additional funds to recapitalize or resolve banks and without burden the finances of the respective sovereign. But as long as banking union (common deposit insurance) or fiscal union remain (debt guarantees) remain incomplete, monetary union will remain incomplete, meaning EMU will remain structurally vulnerable to systemically destabilizing financial shocks, whether they emanate in the government or the banking sector. Then again, the euro area has come a long in terms of strengthening its crisis-fighting ability since the beginning of the Greek debt crisis 15 years ago.