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2018 Special report – Federal budget risks associated with the creation of a European Monetary Fund (EMF)

Nov 02, 2018

0 Executive summary
In response to the financial crisis, the member states of the euro area (euro area countries) established a permanent rescue fund: the European Stability Mechanism – ESM. All 19 euro area countries have joined the ESM. In case of a crisis, the ESM serves to provide stability support to its members, such as loans and guarantees, where such support is fundamental to the stability of the euro area as a whole. The ESM may borrow the funds needed for this purpose from the capital markets.

The initial capital stock of the ESM is €705 billion. €81 billion of this amount was transferred by the members as direct payments that serve as security reserves. Some €624 billion have been committed as callable capital. Each member is liable for losses up to the amount of their individual share in the capital stock. For Germany, such share amounts to €190 billion. The ESM Board of Directors may increase the authorised capital stock. Such an increase is subject to approval by the members in accordance with their respective national procedure.

The European Commission (Commission) and the euro area countries are planning to reform the ESM. In December 2017, the Commission drafted a Council regulation (draft regulation) to this end. The draft regulation is designd to transform the ESM into a true European Monetary Fund (EMF). The terms and conditions of an EMF have been thoroughly discussed at the national and European levels. The euro area countries are seeking to reach agreement on the terms and conditions for further refining the ESM by December 2018.

Against this background, our report is designed to inform Federal Parliament, the Federal Government and the general public about the federal budget risks associated with a reform of the ESM. The report also assesses as to whether and to what extent the Commission’s draft regulation may adversely impact on Germany’s national participatory powers. The status of current deliberations as of 30 September 2018 is reflected in the audit report.

The Commission’s draft regulation aims at providing stability support to members in a more timely and simplified manner. In addition, the provision of stability support shall no longer be subject to compliance with reform requirements (principle of conditionality). The tasks of the EMF are also to be expanded. All reform proposals imply drawing more on the EMF’s financial resources and higher costs of potential bailouts. Also, the reform of the ESM may provide disincentives, e.g. undermine reform efforts taken by crisis-stricken member states.

We believe that – in case the proposed reform is implemented – losses are more likely to occur. It may also become necessary to increase the EMF’s capital stock. For Germany, this would lead to an increased liability beyond the agreed amount of €190 billion. Although such a step would be subject to approval by all member states, Germany may not refuse consent, e.g. if new EMF tasks require credible funding. This would result in additional burdens on the federal budget.

We conclude from this that the creation of the EMF as proposed by the Commission would pose major risks to the federal budget.

According to the Commission’s proposal for reform, the EMF is to form part of a safety net for crisis-ridden euro area banks and to hold up to €60 billion for this purpose. The reform proposal would eventually pool liability risks in the European banking sector and also signalise that, other remedies failing, banking bailouts will continue being funded by the taxpayers.

The Commission intends to use the EMF as a vehicle for policy initiatives. According to the Commission, the EMF could also provide funding for smoothing out cyclical swings in the member states. However, ensuring financial stability of domestic economy is an inherent task of each member state. In our view, there is reason to believe that such funding may have the effect of transfer payments and may also be regarded as such.

The Commission plans to streamline the EMF’s decision-making and to lower the threshold required for votes to pass. If the new legal framework were adopted, Germany might lose its veto powers. Federal Parliament’s participatory powers might also be put at risk.

We recommend to the Federal Parliament issuing an opinion on the reform of the ESM to communicate their position on this matter to the Federal Government. Such a position would then serve as guidance for all Federal Government negotiations at the EU level. The aim should be to bring the reform of the ESM in line with applicable European rules and the key principles of market economy – particularly the principles of liability, ownership and subsidiarity.

Above all, the Federal Government should ensure that

  • all EMF functions and tools are closely aligned with the primary purpose of safeguarding financial stability of the euro area as a whole;
  • stability support is provided only if prerequisites and reform requirements are met, and that this principle of conditionality is not only postulated but also stipulates specified conditions to be met;
  • the euro area countries continue to remain fully responsible for their respective decisions (principle of action and liability);
  • creditors and shareholders of ailing banks and the respective member states are held liable in the first place and that risks posed to the European banking sector are not pooled;
  • Germany’s liability is not expanded;
  • the instruments available to the EMF are not considered as transfer payments and that, as a rule, the recipient reimburses the entire funds and
  • Parliament’s powers to participate in all financial decisions with spending implications remain unconstrained.

The Federal Ministry of Finance commented on the draft report. The Ministry stated that at the EU level the discussions surrounding the reform of the ESM were not linked to the Commission’s draft regulation. At the time of drafting the report, the Ministry said that no projections could be made as to the further development of the ESM.

With regard to discussing the reform of the ESM, the Federal Ministry stated that the Federal Government was seeking to develop a solution ensuring that ESM funds are put to the best use. The Ministry stated that the Federal Government was committed to ensuring that, following the reform, the ESM would still be used as a remedy of last resort only and for its original purpose. Against this backdrop, the Federal Government considered it unlikely for Germany to increase financial commitments or liabilities as an ESM member state. The Ministry added that the Federal Government continued to remind the European partners of meeting domestic constitutional requirements. The participatory powers of the national parliaments would not be negotiable.

We welcome the Federal Government’s efforts towards putting funds to best use in the course of the ESM reform and safeguarding Federal Parliament’s powers to participate in all financial decisions.

However, we reaffirm our stance that Federal Parliament should communicate to the Federal Government their opinion in order to provide a policy statement to guide negotiations at the EU level. This step would, on the one hand, take account of the Parliament’s budget authority. On the other hand, e.g. limits set by Parliament would strengthen the Federal Government’s bargaining position in negotiations at the EU level.

Establishing a European Monetary Fund

Euro area: Focus to remain on effective crisis response

The German SAI considers the European Commission’s proposal to reshape the ESM not to be an adequate approach for making the euro area resistant to crises. To ensure a stable currency union the rescue fund will have to place full focus on its core function of crisis response.

The European Stability Mechanism (ESM) is to be reformed and further developed to become a European Monetary Fund (EMF). The European Commission has submitted a proposal for this purpose.

In the German SAI’s view, the Commission’s plan puts at risk the effectiveness of the rescue fund to provide an adequate response in case of financial and currency crises in the euro area. An EMF structured as the Commission sees fit would lose the role of the ESM that has been a genuine crisis response mechanism for the European economic and monetary union.

”A stable euro currency is of fundamental importance for Europe and Germany. Financial and currency crises in the euro area will have to be overcome in an effective way. For this reason, we need a rescue fund with a support mechanism that is clearly targeted and tailored to the purposes for which it has been created. The rescue fund shall not be overloaded with other functions or even create disincentives”, Kay Scheller, the President of the German SAI, said when he communicated the special purpose report to Federal Parliament. “What we now need is that Federal Parliament takes a more active role in the ESM reform discussion. Parliament should make a clear statement on what direction the ESM needs to take. Parliament should ensure that its participatory powers are not compromised. In the future, major decisions on how the taxpayers’ money is used should not be made without involving national parliaments” Mr. Scheller said.

The regulation proposed by the Commission aims at providing stability support to more Member States in a more timely and simplified manner. Stability support will no longer be contingent upon meeting reform requirements as has been the case so far. The EMF is to form part of a safety net for crisis-ridden euro area banks and to provide up to €60 billion euro for this purpose. Other remedies failing, banking bailouts will thus continue being funded by the taxpayers.

In addition, the EMF is supposed to expand its tasks, for example to mitigate cyclical fluctuations in the Member States.

The German SAI holds that such an expansion of the ESM’s role would result in disincentives for national governments and banking institutions and at the same time weaken the key crisis response function. The EMF’s funds would more heavily be relied on and the volume of defaults would increase.

To remain as effective as possible, crisis response needs to be closely targeted to its purpose and be clearly delimited from other instruments. This is a remedy of last resort and can in no way serve as a substitute for sustainable public sector finance policy. Following the example of other business branches, banking institutions should be held liable for the risks they incur in line with principles governing the market economy.

Against this background, the German SAI recommends to Federal Parliament taking an active role in reform discussions at an early stage. The Federal Parliament could then support the Federal Government in complex negotiations at EU level and provide advice on how to shape the EMF to become an effective mechanism.

Today, the German SAI has communicated the audit report on establishing the EMF to the two Houses of Parliament and to Federal Government.

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