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Analysing The Leveraging Of EFSF
Malaysia Perspective | 23 November 2011

By Yeoh Mei Kei

The European Financial Stability Facility (EFSF) was created by the Eurozone Member States on 9 May 2010 to safeguard the financial stability in Europe by providing financial assistance to Eurozone Member States, if needed. To fulfill EFSF’s mission, it is authorised to:

- Issue bonds or other debt instruments on the capital markets to provide loans to countries in financial difficulties
- Intervene in primary and secondary debt markets
- Finance recapitalisation of financial institutions through loans to governments.

EFSF To Be Leveraged To One Trillion Euros

The European leaders stated that they would like to leverage the EFSF to 1 trillion Euros. The question is, after providing financial assistants to Ireland and Portugal, how is it possible for the remaining amount of EFSF (estimated to be around 290 billion Euros) to turn into over 1 trillion Euros. To enlarge the available fund for financial assistance, EFSF could either

1. Provide a certain level of guarantee to primary bond market buyers, or
2. Form a Special Purpose Vehicle (SPV) to attract more capital.

Under the first approach, EFSF will indirectly be the bond guarantor. As usual, upon receiving requests from countries with financial difficulties, EFSF will issue bonds and lend the fund raised to these countries. As European leaders have agreed to increase the EFSF’s guarantee amount to 780 billion Euros, and the guarantee commitment from 6 Eurozone Member States with AAA credit ratings has also increased to 430 billion Euros, this means that the effective lending power of EFSF (or amount of bonds that EFSF can issue) is at 440 billion Euros. As EFSF issues are backed by guarantees, Moody’s Investor Services, Standard & Poor’s and Fitch awarded it AAA credit ratings, this attracts more foreign investors such as foreign central banks and sovereign funds to purchase the bonds.

Unlike in the past, under this leverage plan, countries who receive EFSF’s loans will not fully utilise it to repay their debts, as part of the loans will be allocated for guarantee purposes. This guarantee ensures that these countries will have the ability to issue bonds in the open market in the future. As interest rate remains high, coupled with the distrust of investors to sovereign bonds and the low sovereign credit rating, Greece and the other PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries are facing difficulties in issuing bonds in the open market. However, we believe that the guarantee could at least improve investors’ confidence going forward, so that these PIIGS countries could continue issuing bonds at lower interest rates.
The first approach is rather complicated, and we will illustrate with the following example. Assume EFSF lends Greece 100 billion Euros after receiving its request for financial assistance. 50 billion Euros will be used to repay its debts, while the remaining 50 billion Euros will be used to guarantee its 150 billion Euros newly-issued bonds. In the case if Greece defaults, investors could at least get back the guarantee amount of 50 billion Euros. This means that the 50 billion Euros of EFSF’s loans enable Greece to issue 150 billion Euros of new bonds, and the leverage ratio in this case will be 3 times. On a gross basis, including the 150 billion Euros of newly issued bonds and the 50 billion Euros of guarantee, Greece received a total of 200 billion Euros, which has doubled the leverage of the 100 billion Euros provided by EFSF. To achieve higher leverage ratios, the guaranteed amount needs to be lower.

After providing financial assistance to Ireland and Portugal, EFSF is estimated to have 290 billion Euros left. If we were to assume that the EFSF loans 100 billion Euros to PIIGS countries or use the 100 billion Euros to purchase PIIGS’s sovereign bonds in order to stabilise the interest rate, the remaining 190 billion Euros will retain as a guaranteed amount. Based on an assumption of a 2 times leverage ratio, the 190 billion Euros of guarantee amount will assist PIIGS countries to generate around 380 billion Euros of new capital via bond issuance. If the 190 billion Euros is four times leveraged, the new capital from bond issuance could be higher at 760 billion Euros.

The Key Issue of Leveraging EFSF – The Guarantee Ratio

If investors are confident of the PIIGS countries, they are likely to accept a lower guarantee ratio. In contrast, if investors do not believe the PIIGS countries’ repayment ability in the future, the guarantee ratio may be as high as 100%, and this means no leverage effect. As the domestic sectors and labour market in Greece lack competitiveness, coupled with high social welfare spending now, the Greek economy is expected to continue to shrink in the foreseeable future. As such, investors are likely to demand a 100% guarantee for Greece’s’ new issuance of bonds. Therefore, we believe that the guarantee from EFSF is likely to benefit bond issuance from Italy and Spain, but have little positive impacts to Portugal, Ireland and Greece.

In additions, we remain concerned about the participation of foreign investors to the SPV (the second approach), especially when this SPV may not be awarded with the AAA credit ratings like EFSF. This, coupled with the complicated structure of the SPV, could lead to central banks and sovereign funds having less interest in purchasing PIIGS bonds through SPV. This will make it more difficult for EFSF to achieve the leverage size that they initially wanted.

* Yeoh Mei Kei is a Research Analyst at

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