The EU’s loans to Greece, Ireland and Portugal are just the tip of the iceberg of a fledgling transfer system that is creeping into the eurozone via the back door. A far bigger and implicit subsidy is growing beneath the surface in the form of TARGET2.
Its full name is more than a mouthful. Trans-European Automated Real-time Gross Settlement System is better known as TARGET2 for short. It is the behind-the-scene payments system that conveniently enables citizens across the euro area to settle electronic transactions in euro. And at just over €500 billion, its TARGET2 claim on the Eurosystem is also the largest and fastest growing item on the Bundesbank’s balance sheet, as well as a source of much misunderstanding and debate.
Money doesn’t die unless hyperinflation renders it worthless. When the European Central Bank (ECB) creates money, as it currently is doing in grand style, it must end up somewhere. The allocation of TARGET2 balances among the seventeen national central banks, which together with the ECB make up the Eurosystem, reflects where the market allocates the money created by the ECB. The fact that the Bundesbank has a large TARGET2 claim (asset) on the Eurosystem, while national central banks in southern Europe and Ireland together have an equally large TARGET2 liability, simply reflects that a lot of the ECB’s newly created money has ended up in Germany. Why? Because of capital flight.
Countries in southern Europe generated persistent current account deficits since joining the euro in 1999, some of them large. A current account deficit means a country spends more in total than it earns. That extra spending is financed by borrowing from abroad. The source for such borrowing comes from a current account surplus country, like Germany. Since the euro eliminated exchange rate risk among its member states, Germany has invested a substantial portion of its savings in Europe’s current account deficit countries. Some of those savings are now returning home. That’s the capital flight.
Enter the ECB. The ECB stepped into the void left by foreign investors pulling their savings out of these current account deficit countries by lending their banks more money. TARGET2 balances thus reflect intra-Eurosystem credits among the national central banks sharing the euro. When large capital flight to Germany occurred before the euro’s introduction, the deutschemark would appreciate against other European currencies. While pegged against the deutschemark, these exchange rates were still flexible. That flexibility disappeared with the euro. When capital flight occurs today, the Bundesbank effectively ends up with loans to the other national central banks that are reflected in the TARGET2 claims on the Eurosystem.
Some commentators have suggested there is a limit to how large the Bundesbank’s TARGET2 claim on its balance sheet can grow, implying a corresponding limit to how much the Eurosystem can lend to banks in the current account deficit countries. The Bundesbank is a long way from reaching this limit. The theoretical limit is imposed by two factors out of the Bundesbank’s control: the amount of collateral banks in southern Europe can muster to borrow more money from the ECB and the amount of capital flight from them.
The pool of eligible collateral in the euro area is enormous. The ECB estimated it at €14 trillion at the end of 2010, and recently introduced rules to allow banks to use even more collateral, albeit of lower quality, to borrow from it. So the collateral for further borrowing exists should capital flight persist.
We see the risk of capital flight continuing. While the ECB’s generous liquidity operations and bond purchases have calmed financial markets down, the eurozone’s long-term structural problems remain. Debt overhangs persist, growth is mediocre and the governance structure – a common monetary policy without a centralized fiscal policy – is a challenge. History is fraught with monetary unions that broke up because they did not progress to political and fiscal union. What should convince us that this time is different?
The Bundesbank’s balance sheet is thus capable of growing further so long as capital flight to Germany from southern Europe continues and the Eurosystem lends more money to its banks. It might not like it, but there is no limit on the Bundesbank’s balance sheet and no mechanism within TARGET2 to prevent this event from occurring. The Bundesbank’s TARGET2 claim on the Eurosystem on the asset side of its balance sheet will likely increase, while on the liability side it will simply become a net borrower of deposits from Germany’s banks, which it has been since August last year.
The ECB has allowed banks to borrow as much money as they want for up to three years. Indeed, at the end of February banks were borrowing €1.2 trillion from the ECB, twelve times the amount of their required reserves. With so much excess liquidity in the money markets, further capital flight is likely to cause a disproportionable share of this money to end up in Germany.
Three discernible consequences will likely come out of this cheap money and capital flight mix: inflation in Germany will increase, the internal devaluation process underway in southern Europe will proceed slowly and it will strain the political foundation of the euro.
Evidence so far points to accelerating asset price inflation in Germany rather than consumer price inflation. Capital flight and their “safe haven” status have inflated the prices of German government bonds. Concerned about the stability of the euro, Germany’s savers are shifting their money into real estate. German residential house prices and rents rose by 4.7% last year, the fastest increase since 1993’s reunification boom. So far, Germans are not leveraging to buy houses. Growth in German mortgages is paltry at just 1.2% per annum according to the ECB as of December 2011, but in our view all ingredients for a debt-financed house price boom are there. Distrust in the euro is rising, German households’ debt level is low, as are interest rates and unemployment. The ECB’s monetary policy is too loose for Germany’s domestic conditions, just as it was too loose for Spain and Ireland in the early years of monetary union when Germany’s economy was weak.
Asset and consumer price inflation in Germany would make it a borrower’s paradise. While more inflation and demand will whittle down the country’s current account surplus, policymakers shouldn’t underestimate the mobility of capital or Germany’s desire for price stability. If people perceive the ECB is turning a blind eye to inflation in Germany while southern European countries undergo fiscal austerity, fleet-footed savers will likely get both their money out of euros and into real assets.
The ECB’s generous monetary policy will delay the internal devaluation adjustment of the eurozone’s current account deficit countries. The aim of internal devaluation is simple: lower a country’s price level relative to one’s trading partners’ so as to restore international competiveness. This can help reduce a current account deficit in the same way large exchange rate depreciation does. But internal devaluation is bitter medicine compared to exchange rate devaluation. Tightening fiscal policy to lower wages and implementing structural reforms to raise productivity seldom get politicians re-elected. Like a painkiller, money supplied by the Eurosystem to banks in these countries generally helps smooth the internal devaluation process. But like too much morphine, too much money can defeat the purpose.
Greece’s current account deficit was still 9% of GDP at the end of last year, only one percentage point lower than in 2010, despite the country being in recession for three consecutive years. The adjustment would most certainly have been larger and faster had the ECB not filled in for the capital flight. Mexico’s current account deficit fell by 5.3% of GDP in 1995, according to Haver Analytics, in the wake of capital flight following the government’s decision to float the peso in 1994, while its recession lasted only one year. Greece lacks Mexico’s policy flexibility to make such a swift adjustment. After falling 3.7% last year, Greece’s unit labour costs will have to fall a further 10% just to reach the eurozone average and a full 25% before reaching Germany’s level. Greece is stuck in a slow-growth rut with painful social costs ahead of it in order to regain competitiveness.
A further expansion of the Bundesbank’s TARGET2 claim on the Eurosystem will likely strain the euro’s political foundations. Large and divergent TARGET2 balances of the Bundesbank and periphery central banks are a natural consequence of monetary union without fiscal union. As Ulrich Bindseil and Philipp König point out in a 2011 discussion paper, “The Economics of TARGET2 Balances,” this is a natural consequence of how a monetary union functions. But when pushed to an extreme, as is currently the case, monetary policy ends up substituting for fiscal policy without going through the same democratic channels that governments’ expenditure and taxation decisions entail.
The large TARGET2 positions developing among national central banks de facto introduce transfer and burden sharing elements of a common fiscal policy to the euro area without democratic taxpayer representation. Taxpayers in the eurozone are contingently liable for eventual losses incurred by the Eurosystem’s monetary policy operations according to each country’s share of the ECB’s paid-up capital, in Germany’s case 27%, in Greece’s 3%. Were Greece to leave the euro area, for example, and default on its €109 billion TARGET2 liability (as of November 2011), taxpayers in all other eurozone countries would shoulder the loss with Germany on the hook for the largest slice. The EU’s loans to Greece, Ireland and Portugal are thus the tip of the iceberg of a transfer system that is creeping into the eurozone via the back door. A far bigger implicit subsidy is growing beneath the surface in the form of TARGET2 imbalances without the legitimization that the electoral process entails. No wonder voters in the euro area’s current account surplus countries increasingly mistrust the euro.
We would not be surprised if Greece’s most recent bailout program goes off track, like the programs before it, owing to the high social costs of internal devaluation. Regaining policy flexibility outside the eurozone may prove to be a more compatible choice than suffering multiple years of fiscal austerity without even achieving debt sustainability. We therefore intend to stay away from investments in Greece and Portugal, which look very similar.
We would be very surprised, however, if Europe’s leaders would allow the eurozone to break up. Germany’s explicit and implicit claims on periphery countries amount to about one-third of its annual national income, reason alone to take the monetary union a stage further. Today’s muddle-through policy responses, doing just enough to get around the next corner, make for volatile capital markets. As the Delors Report in 1989 mapped out a long road to monetary union, a road map to the distant destination of fiscal union should help long-term investors to better withstand the volatility along the journey. Until we see more clarity along this bumpy journey, we will remain cautious with our exposures to Italy and Spain.