What it means
The facility was created in the middle of the euro-area debt crisis, when investors lost confidence in the finances of some governments. Countries such as Greece, Ireland and Portugal could no longer borrow from markets at affordable rates.
The EFSF was designed to provide emergency loans so these countries could keep paying their bills. Its structure was unusual.
The EFSF itself had little capital, but the euro-area governments guaranteed the bonds it issued. Because the guarantors were mostly strong economies, the EFSF could borrow at low rates and lend on to borrowers with a small margin.
Loans were not free money. Recipient countries had to agree to economic reform programmes, which usually involved spending cuts, tax changes and structural reforms.
These conditions were often debated, and they affected the lives of many ordinary people in the countries concerned. The EFSF was always meant to be temporary.
In 2012, a permanent institution, the European Stability Mechanism, began operating, and the EFSF stopped making new loans once the new body took over. The EFSF continued to exist to manage its outstanding loans and bonds until they were repaid.
For finance professionals, the EFSF is a case study in how governments can use guarantees to stabilise a crisis. Its bonds were seen as high quality and were bought by banks, pension funds and central banks.
The episode also showed how the financial health of governments and banks can be tied together. Understanding the facility helps explain later developments, such as the creation of tools to support the euro.
It also shows the trade-off between helping a struggling member and limiting the risk to taxpayers elsewhere. Most of the debate was about who should carry the cost if loans were not repaid.
In practice
Real-world examples.
Example
A government with soaring borrowing costs receives a loan from the facility at a much lower rate than the market demands. The loan gives it time to carry out reforms without defaulting on its debts. The government must report regularly to its lenders on progress against agreed targets.
Example
A pension fund in Germany buys bonds issued by the facility because they carry guarantees from several governments. The fund treats them as a safe holding that pays slightly more than domestic government bonds. Its investment committee records the guarantee structure as the reason for treating the bonds as low risk.
Example
An economics student compares the facility with the later permanent mechanism. She notes that the second body has paid-in capital, whereas the first relied on guarantees. Her essay argues that actual capital gives lenders more confidence than promises alone.
Formula
Calculation
Interest cost passed on to the borrower = EFSF funding cost + margin
Worked example: suppose the facility borrows 1,000,000,000 euros by selling bonds at a funding cost of 2.00% a year, and it lends the money on with a margin of 0.50% to cover its costs.
Step 1: Rate charged to the borrowing country = 2.00% + 0.50% = 2.50%.
Step 2: Annual interest paid by the country = 1,000,000,000 x 2.50% = 25,000,000 euros.
Step 3: The EFSF uses 20,000,000 euros of this (1,000,000,000 x 2.00%) to pay bondholders and keeps the 5,000,000 euro margin.
The figures are illustrative and do not describe any actual loan. The key point is that a country with a good credit rating lending through guaranteed bonds can offer cheaper funding than the borrower could find alone.Case study
Seen in the real world.
Marenco Republic is a fictional country whose government borrowed heavily to fund public spending. When investors doubted its ability to repay, yields on its bonds jumped to levels it could not afford.
A rescue facility similar to the EFSF lent Marenco 20 billion euros over three years in return for reforms. The fresh funding calmed markets, and borrowing costs on the country's ordinary bonds fell by several percentage points. Businesses in Marenco also benefited, because banks became willing to lend to them again at lower rates.
In this illustrative story, Marenco's reforms were painful, as they included a rise in the retirement age and cuts to public salaries. By the end of the programme, however, the country returned to the bond market and began to repay the rescue loans.
Watch out
Common mistakes.
- Believing the EFSF was a bank with its own large capital, when it relied on guarantees from member governments.
- Assuming that it gave grants, when its funds were loans that had to be repaid with interest and came with conditions on reforms and spending.
- Confusing the EFSF with the permanent European Stability Mechanism that replaced it.
Questions
People also ask.
Why was the EFSF created?
It was set up to prevent euro-area countries from losing access to funding during the debt crisis.
Is the EFSF still lending?
No, new lending moved to the European Stability Mechanism, and the EFSF continues only to manage its existing loans and bonds.
Who guaranteed the EFSF's bonds?
The euro-area governments guaranteed them, in proportion to their share in the arrangement. Because several strong economies stood behind the bonds, investors treated them as very safe.
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