Flooring the ESM

"Assuming there are no voting hiccups in getting the ESM to buy sovereign bonds on the secondary market…
Some arguments that bailout fund’s limited size means it will eventually hit a floor which will ultimately make bond market liquidity worse.
From Munchau in the FT:

The real constraint for ESM bond purchases had less to do with the rules than with the overall size limit of the ESM. It has a lending capacity of €500bn – and that has not changed. No matter how you twist and turn it, the ESM is simply not big enough. It will inject equity into Spanish banks. It will need to refinance the programme for Greece, Ireland, and Portugal. It will soon have to cope with Cyprus and, who knows, maybe Slovenia as well. A full-scale programme for Spain still looks likely.

If you accept the premise that the ESM as currently constituted will not be able to cope with the costs it will soon have to bear, you then have to deal with the consequences of a floor being hit.
Paul De Grauwe argues in an excellent article on Vox (that is worth a read in full) that as soon as the ESM starts intervening, it will quickly destabilise the government bond markets it is attempting to stabilise:

The reason is the following.
Suppose a new movement of fear and panic, triggered for example by the deepening recession in Spain, pushes up the Spanish government bond rate again.

• – To stem the tide the ESM starts buying Spanish bonds. Suppose it buys €200 billion worth of Spanish bonds.

At the end of the operation it will be clear for everybody that the ESM has seen its resources decline from €500 billion to €300 billion. Less will be left over to face new crises.

• – Investors will start forecasting the moment when the ESM will run out of cash.

They will then do what one expects from clever people.

• – They will sell bonds now rather than later.

In a way, the closer the ESM gets to its floor, the more it will act in the same manner as depleting foreign reserves – focusing minds on the exit in the knowledge that the longer they stay the shakier the edifice will get. So, first mover advantage would bring the crisis forward.
Concerns about the ESM’s limit were raised from the start and it remains to be seen if an agreement to lift its limit if the floor is reached would be enough to offset the fears of a floor being reached eventually anyway..."

at http://ftalphaville.ft.com/blog/2012/07/03/1070061/flooring-the-esm/