Markets will test eurozone claims of strength

Details of permanent mechanism now in place as Germany wins longer timeframe for contributing.

● No to a bail-out (for the time being)

● Support for nuclear safety tests

● Encouraging growth

● Show of unity on Libya marred by criticism of French leadership

The eurozone now has the tools to deal with future crises as well as economic policies to prevent a repeat of the meltdowns of the Greek and Irish economies last year. These were the bold claims made by eurozone leaders at the end of the 24-25 March European Council.

The first of those claims is likely be tested soon if, as widely expected, Portugal is forced to call for multi-billion-euro assistance from the eurozone and the International Monetary Fund.

José Manuel Barroso, the European Commission president, said at the end of the summit on Friday: “In the unlikely event we need it, we have real firepower in place.” He was referring to the agreement on the detailed arrangements for financing a permanent eurozone rescue fund, the European Stability Mechanism, able to lend €500 billion to eurozone countries in financial difficulties.

The deal to set up the mechanism was reached in principle in December. Eurozone finance ministers agreed at the start of last week (21 March) that the mechanism, which will have €700bn in assets, should receive paid-in capital of €80bn, with the remaining €620bn in ‘callable’ capital and government-backed guarantees.

Germany will provide €190bn of the mechanism’s total capital base, but the Free Democrats in the country’s governing coalition objected to paying €11bn in 2014, as they hope to be able to cut personal taxes in that year.

Angela Merkel, Germany’s chancellor, won a longer timeframe for contributing, and the start-up capital will now be provided in five instalments, rather than four, starting in July 2013.

While the solution helped Germany, it created additional problems for other eurozone countries such as Italy, which do not have the benefit of a triple-A credit rating and must provide callable capital rather than guarantees.

Lending capacity

Fact File

To the rescue 

How the European Stability Mechanism will work:

It will succeed the European Financial Stability Facility from June 2013

It will have an effective lending capacity of €500 billion and subscribed capital of €700bn

€80bn in paid-in capital will be provided by eurozone countries from July 2013 (paid in five equal instalments), and callable capital and guarantees will be worth €620bn

Between 2013-17, member states have agreed to provide, if necessary, appropriate financial instruments more quickly to maintain a 15% ratio between paid-in capital and the outstanding amount of ESM issuances

The contribution key will be based on the European Central Bank capital key. Countries with a per capita gross domestic product of less than 75% of the EU average will have a temporary correction for 12 years after joining the euro (three-quarters of the difference between gross national income and ECB capital shares)

The ESM will be able to buy on the primary market the bonds of a member state experiencing severe financing problems

Pricing of loans: ESM funding cost, plus a charge of 200 basis points (bps) on the entire loan and a surcharge of 100bps for loans for more than three years

There will be collective action clauses for private-sector involvement

The ESM will have preferred creditor status

If Portugal cannot fund its debt on capital markets and needs to seek assistance, it will be provided by the European Financial Stability Facility (EFSF), an existing temporary mechanism to be replaced by the ESM in 2013.

An agreement in principle by eurozone leaders on 11 March to increase the effective lending capacity of the EFSF from around €250bn to €440bn will also require participating countries to increase their contributions. The Finnish government cannot win parliamentary approval for the higher contribution until after elections on 17 April. Leaders at the summit therefore set a deadline of June to agree the necessary changes to the EFSF.

Barroso also claimed on Friday that the EU had agreed a new set of economic governance rules that would ensure that the crises of the last 12 months are not repeated. He referred to the euro-plus pact, which requires countries to ensure that national economic policies improve competitiveness. The measures include monitoring developments in unit labour costs, ensuring that pension and welfare systems are affordable, and working on tax co-ordination. Barroso also noted tougher rules for the Stability and Growth Pact, with countries facing financial penalties for breaching debt and deficit limits.

The outcome of the summit was a victory for the German vision of how to maintain the stability of the eurozone, with Berlin-style control of wage inflation and strict limits on public spending. Unsurprisingly, Merkel expressed satisfaction, insisting that, after the global crisis plunged parts of the eurozone into acute financial difficulties, “the euro has passed its first test because everyone has backed the euro politically”.

As the demise of the Portuguese government shows, pushing through the economic reforms needed to reassure financial markets that eurozone countries can manage their debts comes at a very high political cost. The true test of the agreement reached at last week’s summit will be whether other governments are prepared to pay that price, and, if they do, whether they can survive the wrath of voters.