New Euro Bailout Fund Could Fall Short

The new fund set up to bail out struggling euro zone economies may face a 150 billion euro ($189 billion) shortfall if Spain and Italy need a full bailout program before the end of 2014, according to analysts at Credit Suisse.

However, its firepower could be significantly improved if the European Central Bank (ECB) intervenes in secondary bond markets – an outcome which has been rumored in recent weeks. (CNBC Explains: How Does the European Central Bank Work?)

The European Stability Mechanism (ESM) is one of the key pillars of euro zone leaders’ attempts to deal with the debt crisis which threatens to spread its tentacles ever further. It’s expected to come into force later this year, as a replacement for the European Financial Stability Facility (EFSF), if the German Constitutional Court rules positively on it on September 12th.

When it was first announced earlier this year, the ESM sparked a rally in markets, as traders hoped it would help break the cycle of hopes rising, then being dashed, for a solution to the euro zone debt crisis.

However, as Spain and Italy have looked more likely to be in need of a full bailout, worries have grown about its size. The ESM is dependent on contributions from euro zone member states, with Germany its biggest contributor. Growing dissatisfaction in Germany about the cost of saving peripheral euro zone economies could threaten its firepower – and limit the potential to increase its size which is written into the treaty.

According to Credit Suisse analysts, the ESM in its current state would at most provide a full bailout to Spain for one year. (Read More: Will Spain Seek Full Bailout?)

The ESM’s full lending capacity, which will be reached in 2014, will be around 400 billion euros, according to the bank’s figures. While the official maximum lending capacity is 500 billion euros, when liabilities for existing bailouts are taken into consideration, the total is 408 billion euros. (Read More: Bailout Fund Should Buy Debt)

The fund’s power may be most felt in its ability to buy government bonds on the primary and secondary markets. This could help keep steady bond yields for Spain and Italy – which in recent weeks have climbed above the dangerous 7 percent level where other countries had to seek bailouts.

“The capacity of the ESM is now of reduced importance,” Credit Suisse analysts wrote in a research note.

It should only be able to buy up to 50 percent of final issued bonds, but if this means that it can match what is bought by the market, it could help reassure investors, particularly if the ECB was also in the market.

Whether the ECB will support the bond market by intervening to support Italian or Spanish bond yields is one of the questions keeping markets awake at night. Germany has maintained a stalwart opposition to the idea, and Jens Weidmann, chief executive of the Bundesbank, warned that it could become “addictive like a drug.”

CNBC