THE NO BAIL-OUT PRINCIPLE IN THE EURO AREA S RESCUE MECHANISMS Mojmír Helísek

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1 THE NO BAIL-OUT PRINCIPLE IN THE EURO AREA S RESCUE MECHANISMS Mojmír Helísek University of Finance and Administration, Estonská 500, , Praha 10 mojmir.helisek@vsfs.cz Abstract: To overcome the debt crisis, which takes place in some euro area countries, especially the European Stability Mechanism was created. Many authors argue that it is a breach of the no bail-out principle (prohibition of the financial aid). The paper deals first with the question what is the content of the no bail-out principle? Another question is whether the ESM assistance is a violation of this principle? The no bail-out principle is interpreted according to the Treaty on the Functioning of the EU. This principle means a prohibition of the liability for commitments or a prohibition of assumption of commitments by the Union or a Member State. A comparison of this interpretation with forms of assistance provided by the ESM leads to the conclusion that the no bail-out principle is not violated. The paper also discusses this conclusion in the context with the prospects of the euro s introduction in the Czech Republic. Keywords: No bail-out, debt crisis, European Stability Mechanism, euro area, bail-in. JEL classification: E 42, E 44, F 15 1 Introduction The debt crisis that affected some countries of the euro area led to the development of rescue mechanisms that should mitigate this crisis or help find solutions and prevent the situation from happening again. These mechanisms call for discussion as to whether they contradict the principles of the monetary union, specifically with the principle of no bail-out (prohibition of assistance), described in the Treaty on the Functioning of the European Union. The goal of this paper is to answer the question, of what exactly stands for the no bail-out principle? Let s find the answer in the Treaty on the Functioning of the European Union (TFEU). Another question is whether granting assistance through the European Stability Mechanism (ESM) leads to the breach of this principle? To this end, relevant forms of assistance provided by ESM are examined. The conclusion offers evaluation whether the no bail-out principle is breached or not, i. e. whether the European Stability Mechanism questions or does not question the credibility of the institutional organization of the euro area. It does not involve an academic discussion only. Reservations towards rescue mechanisms (as well as towards the credibility of the euro area) are used as argumentation to question the obligation to replace the national currency with the euro. 1 Clarification of this question has therefore practical economic-political relevance. 2 Literature Review Criticism of the rescue mechanisms, especially the European Stability Mechanism, brought about by breaching the principle of no bail-out, can be found e.g. in the work by T. Sarrazin Europe doesn t need the euro. The European Union should insist on declaring insolvency by the governments of debtor countries. All of this would be in line with the Maastricht Treaty. T. Sarrazin is also a harsh critic of all safety mechanisms that negate this principle. An exception in the form of 1 This questioning of the obligation to accept the euro occurs only at the level of discussions, both expert and political. However, it is not mentioned in any official government statements. We might come across a hint at the change of conditions of the euro area functioning in comparison with the situation when the Czech Republic was entering the EU and committed itself to accept the euro (see the Ministry of Finance, Assessment, 2013, p. 3).

2 applying the bail-out principle (i.e. to provide assistance) would be admissible if the mistrust in the bonds of some countries were not based on their enormous debt. Creation of the European Financial Stabilisation Facility (EFSF) in 2010 and the European Stability Mechanism in 2012 resulted in the legalization of the bail-out policy. It happened under the pressure of the argumentation that if any country decided to leave the single currency, the markets would stop believing in the future of the euro. Sarrazin (2012) first claims that the supporters of the bail-out system are the owners of state bonds, i.e. mainly banks that want to be protected against losses (p. 185). However, what makes them believe that the creation of ESM has breached the no bail-out principle? While in case of the EFSF [ ] the breach of the no bail-out principle could be justified by a temporary state of deficiency, in case of the ESM [ ] the policy of the bail-out system is legalized by amending the contract. There will be a new regulation (article 136, paragraph 3 of the Treaty on the Functioning of the European Union) which shall authorize euro states to create such a mechanism. [ ] However, now relevant [debtor] states can decide to what extent this principle is still true by judging from the form of the future promised assistance (p. 188). We can find other critics of the euro area rescue mechanisms among works presenting Czech or Slovak experts, e.g. in the anthology of Krutílek, O., ed. (2013): - the prohibition of the so-called bail-out was omitted, i.e. contractual provision prohibiting the payment of government debt by other countries (or the guarantee), we have abandoned the principle that every country is responsible for its debt (author S. Janáčková, p. 24, 25); - European leaders [ ] breach the no bail-out clause [ ] the ESM permanently transfers financial backing of irresponsibility of the government and financial institutions to tax payers (also) in other countries (author P. Gonda, p. 63, 64). In another publication, S. Janáčková (2014) claims: [ ] the euro area saw something that can be called a change of rules in the course of the game. We have abandoned a certain principle which says that every country is responsible for its debt and other members are not obliged to grant fiscal assistance in any way (p. 99). Also, P. Mach (2012) believes that the EU breaches the prohibition of rescue of bankrupt states and that the Member States of the euro area slavishly ( irrevocably and unconditionally ) commit themselves to paying hundreds of billions in favour of this debt union (pp. 55, 60). On the other hand, O. Dědek (2014) points out that bail-out (financial aid) is no gift but assistance offered under strict conditions (p. 297). He also points out that this interpretation of the Treaty on the Functioning of the European Union was decided by the Court of Justice of the European Union in 2012: the aforementioned Treaty does not imply that it prohibits the assistance provided by the EU or other Member States to another Member State if it applies to assistance that does not exempt the beneficiaries of the assistance from responsibility for their obligations. Similarly, for example, Schäfer (2012) points out that most legal experts agree that the no bailout principle does not rule out direct credits of member states to another distressed member state as in the case of Greece or Ireland. The no bail-out principle does not rule out credits channeled through organizations such as the ESM (p. 186). 3 No bail-out and the Treaty on the Functioning of the European Union The expression bail-out stands for assistance, aid, rescue, i.e. its negative form of no bail-out means prohibition of assistance, aid and rescue. 2 What does the Treaty on the Functioning of the European Union prohibit? The assistance regulations are specified in article 125, paragraph 1 of the TFEU. The aforementioned article reads: 2 Also in compounds: bail-out fund, bail-out mechanism, no bail-out clause, bail-out package, bail-out money, no bailout principle etc. (

3 The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. 3 (Text highlighted by M. H.) The Treaty does not prohibit assistance, but liability for the commitments and assumption of the commitments. In this context, the expression of no bail-out has to be interpreted not as prohibition of assistance, but only as prohibition of liability for the commitments and prohibition of assumption of the commitments. The ESM set-up was allowed by supplementing art. 136 of the Treaty on the Functioning of the European Union. This article was amended by the European Council Resolution dated Article 136 was supplemented with a new paragraph: The Member States whose currency is the euro may establish a stability mechanism to be activated if indispensable to safeguard the stability of the euro area as a whole. The granting of any required financial assistance under the mechanism will be made subject to strict conditionality. 5 The supplement of the Treaty on the Functioning of the European Union makes it clear that: - it does not introduce the possibility of liability for the commitments or assumption of the commitments, - it does not prohibit other forms of financial assistance. 4 Assistance provided by the European Stability Mechanism The debt crisis of some countries of the euro area initiated the set-up of several rescue mechanisms. In May 2010, the European Financial Stability Facility (EFSF) was introduced. It was created for a temporary period of 3 years and granted loans to those governments of the euro area that could not take out a loan at an acceptable interest rate on financial markets. In addition, it issued its bonds at the capital market. The debt produced this way is guaranteed by the member states of the euro area at a ratio based on their share in the capital of the European Central Bank (ECB). 6 The volume of bonds, which the EFSF could sell, was determined by the degree of the guarantee from countries involved in the EFSF. The original amount was EUR 440 billion; later it was increased to EUR 780 billion. As a consequence of various insurance policies that were necessary for maintaining the high rating of the EFSF bonds, the EFSF effective loan capacity first amounted to EUR 250 billion, then to EUR 440 billion. In connection with expanding the EFSF loan capacity, there was also a wider scope of financial assistance tools from loans to other tools that were subsequently taken over by the ESM (see hereafter). The only exception were loans for the recapitalization of the banking sector that were in case of the EFSF granted to governments only and not to banks as it is possible in the ESM. In addition to the EFSF, the European Financial Stabilisation Mechanism (EFSM) was also created in May 2010 with the loan capacity of EUR 60 billion, for granting loans to any EU country, not only to the euro area, as it is the case of the EFSF. The EFSM debt is guaranteed by the EU budget, i.e. by the EU member states, proportionally by the key of their contributions to this budget. 3 Consolidated Version of the Treaty on the Functioning of the European Union. 4 European Council Decision of 25 March 2011, p. 2. This amendment to EU establishing agreements was also adopted in the Czech Republic, specifically by the Senate on and by the Chamber of Deputies on Consolidated Version of the Treaty on the Functioning of the European Union. 6 The share in the ECB capital is determined by the share of the relevant country in the population and the EU GDP (with the same weight of both indicators).

4 As of 8 October, 2012 (originally planned as of July 2013) the EFSF agenda was taken over by the European Stability Mechanism. The ESM set-up, the international government organization residing in Luxembourg, was decided on by a contract signed by the Ministers of Finance of the euro area countries on and certified at the European Council Summit on The ESM members are member states of the euro area; non-member states can participate in the ESM financial operations (as providers) on a bilateral basis ad hoc. The ESM functions differently from the EFSF. It has capital subscribed totalling EUR 700 billion, of which EUR 80 billion will be paid-up capital (in ) and EUR 620 billion, the so-called disposable capital in the form of capital that will be granted if needed by the ESM member states. It refers to capital due upon request. The ESM loan capacity totals ca EUR 500 billion, given the need to create a reserve fund and some other tools of the so-called credit enhancement. The allocation specifying the size of the contribution of capital of relevant ESM member states was determined by the ECB paid-up capital with the exception of less developed countries (below the limit of 75 % GDP per capita of the EU average) that had been granted an advantageous allocation for a temporary period of 12 years since joining the euro area. The preference decreases their capital subscribed at the expense of more developed countries. Besides the capital subscribed (paid-up and disposable), the ESM can take out a loan at capital markets, in the form of bond issues with the maturity of 1-30 years. The financial assistance provided by the European Stability Mechanism, the so-called stability support has following forms (based on the Treaty Establishing the European Stability Mechanism): - ESM precautionary financial assistance an offer of lines of credit to governments that have difficulties with paying off their debt, however, the markets did not completely lose trust in them, - financial assistance for the re-capitalisation of financial institutions i.e. to grant loans directly to banks, contrary to the EFSF when the loans were granted to governments and from them subsequently to banks, which led to increased government debt, - ESM loans short-term and medium-term loans to governments, - primary market support facility purchases of government bonds on the primary market, i.e. directly at auction sales of the Ministry of Finance of that respective country, - secondary market support facility intervention in secondary i.e. bank-to-bank markets of government bonds. There are certain conditions of the economic and budget discipline, incorporated in the so-called macro-economic adjustment programme, which have to be met in order to be granted the assistance. An essential condition for providing assistance is also the fact that the financial stability of the whole euro area is threatened. Applications for a loan are assessed by the European Commission together with the ECB and the International Monetary Fund (IMF) and following this evaluation the conditions for financial assistance are determined. The involvement of the International Monetary Fund is advisable (and it s the usual practice) not only at the expert level but also at the financial one. The ESM financial assistance has the so-called seniority status, which means that the ESM has the status of preferential creditor in case of insolvency of an indebted government or a bank (however after the IMF). Its claims are preferred to the claims of the private sector. The EFSF did not create this status. The summary of the aforementioned forms of assistance granted by the EFSF, EFSM and ESM implies that it does not involve liability for the commitments, or assumption of the commitments of a EU Member State by another EU Member State or the EU bodies. Functioning of these rescue mechanisms does not therefore contradict the no bail-out principle. 7 Treaty Establishing the European Stability Mechanism, signed on and supplemented on

5 The same conclusion applies in cases when due to insolvency of indebted governments or banks, these obligations would have to be paid by their guarantors, i.e. governments participating in the EFSF mechanism, the EU budget in case of the EFSM or the government subscribing capital in case of the ESM. Not even in these cases are the governments as debtors towards the EFSF, EFSM or ESM exempt from the obligation to pay. It is not about the responsibility for their commitments or undertaking their commitments. 8 The no bail-out principle has not been breached in this case either. Loans granted from the stabilization mechanisms are connected to interest that has to cover at least the refinance cost. If the loans granted from the stabilization mechanisms were duly paid off including the interest, the ESM would make a profit that would be split among the ESM member states. In case of some countries, this profit could exceed the costs related to the ESM funding. 9 5 Participation of the private sector bail-in Assistance granted from the sources of the European Stability Mechanism can be accompanied by the involvement of the private sector in this assistance. This requirement is in line with the Treaty Establishing the European Stability Mechanism. This involvement must be effected in accordance with the IMF practice, as part of the macro-economic adjustment programme in an adequate and proportionate form, in exceptional cases (Preamble, par. 12). This involvement is described as bail-in, i.e. self-help, or involvement in losses, when the responsibility is partially transferred to the creditor. The application of the bail-in principle indicates debtor s efforts to deal with the debt issue. For the first time, the bail-in principle was applied during assistance granted by the European Stability Mechanism, in case of Cyprus in 2013 while arranging loans necessary for the consolidation of the Cyprus banking sector. Technically speaking, it was extra taxation of bank deposits over EUR (rates of %) at closed bank Cyprus Popular Bank; 10 at the Bank of Cyprus there were transfers of a part of deposits to the bank stock and other measures. In case of the EFSF, it was a partial state bankruptcy of Greece early March The Greek Government agreed with private creditors on replacing the current bonds worth EUR 172 billion with new bonds of lesser value, which meant 53.5 % depreciation of the claims value. We d better describe this measure as selective restructuring of the debt than the state bankruptcy. 6 Conclusions Supplementing article 136 of the Treaty on the Functioning of the European Union allowed the setup of the European Stability Mechanism. Its operations are criticised for breaching the principle of prohibition of assistance (no bail-out), which is defined in article 124 of the Treaty on the Functioning of the European Union. Bail-out can be interpreted only as liability for the commitments or assumption of the commitments. Neither the supplement of art. 136, nor the ESM operations, however, this does not mean. It involves granting financial aid mainly in the form of loans that is conditioned by observing the previously agreed macro-economic adjustment programme and which is interest-bearing. 8 This fact is pointed out in case of the EFSF by Dědek (2014, p. 301). 9 That might also be the case of the Czech Republic if it were the ESM member (see Chmelař et al., p. 52: The Czech Republic might benefit quite a lot from the contribution to the ESM in case of a subdued crisis and by maintaining its low interest rates and inflation ). 10 Nevertheless with numerous exceptions e.g. the taxation did not apply to Greek deposits.

6 The above-mentioned information implies that in the justification of the ESM operations it is not necessary to refer to the application of solidarity principles mentioned in article 122 of the Treaty: 11 - solidarity during serious situations concerning difficulties with the supply of e.g. energy products, - solidarity during natural disasters or emergencies uncontrollable events. The same applies to guarantees granted by the member states to the European Financial Stability Fund or to the subscribed capital granted by the ESM member states to this mechanism. Providing financial assistance through the European Stability Mechanism is therefore not in breach of the Treaty on the Functioning of the European Union. This financial assistance therefore does not deny the rules of the euro area s functioning. This article is one of the outputs of the research projects Introduction of the euro in the Czech Republic progress in preparations or change of obligation?, funded as part of a specific university research at the University of Finance and Administration for References [1] Baldwin, R., Wyplosz, C., The Economics of European Integration. Fourth Edition. Mc Graw Hill: Maidenhead. [2] Chmelař, A. et al., Ekonomické vyhodnocení členství České republiky v Evropské unii po deseti letech. Alternativní scénáře a kvantifikace. Sekce pro evropské záležitosti Úřadu vlády České republiky [Economic Evaluation of the Czech Republic's Membership in the European Union after Ten Years. Alternative Scenarios and Quantification. Department for European Affairs of the Government of the Czech Republic. In Czech only] Available at: [ ] [3] Dědek, O., Doba eura. Úspěchy i nezdary společné evropské měny [Time of the Euro. Successes and Failures of the Common European Currency. In Czech only]. Linde: Praha. [4] Janáčková, S., Peripetie české ekonomiky a měny aneb nedejme si vnutit euro [Peripeties the Czech economy and the Currency or Do Not Be to Impose the Euro. In Czech only]. Institut V. Klause: Praha. [5] Krutílek, O. (ed.), 2013.Euro v Česku: Ano, či ne? [Euro in the Czech Republic: Yes or No? In Czech only]. Studio Arx: Brno. [6] Mach, P. Jak vystoupit z EU. Druhé vydání [How to Withdraw from the EU. Second edition. In Czech only]. Dokořán, Praha, [7] Ministry of Finance of the Czech Republic and the Czech National Bank, Assessment of the Fulfilment of the Maastricht Convergence Criteria and the Degree of Economic Alignment of the Czech Republic with the Euro Area. Available at: [ ] [8] Sarrazin, T., Europa braucht den Euro nicht. Wie uns politisches Wunschdenken in die Krise geführt hat. Deutsche Verlags-Anstalt: München. [9] Schäfer, H.-B., The Sovereign Debt Crisis in Europe, Save Banks Not States. The European Journal of Comparative Economics, vol. 9, issue 2, pp This official response is allowed by Baldwin, Wyplosz, 2012, p However, at the same time they claim that by establishing the ESM the governments are not obliged to guarantee the obligations of other governments, they just offered loans.

7 Treaties and documents [1] Consolidated Version of the Treaty on the Functioning of the European Union. Official Journal of the European Union. C 83/ Available at: [ ] [2] European Council Decision of 25 March 2011 amending Article 136 of the Treaty on the Functioning of the European Union with regard to a stability mechanism for Member States whose currency is the euro. Available at: [ ] [3] Treaty Establishing the European Stability Mechanism, Available at: [ ] Informations from websites [1]

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