Why Germany's TARGET2-Based Eurozone Preservation Mechanism Is Merely A Ticking Inflationary Timebomb
We have covered the topic of the German TARGET2 imbalances previously, both from the perspective of what catalysts can lead the Bundesbank to suffering massive losses (the one most widely agreed upon being a collapse of the Eurozone, which explains why even discussions of that contingency are prohibited in Europe), from the perspective of its being an indirect current account deficit funding mechanism, and from the perspective of what is the maximum size TARGET2 imbalances, funded primarily by the Bundesbank, can grow to before eventually causing irreperable damage to the Bundesbank. Still, there appears to be ongoing mass confusion about the topic, with numerous economists proposing contradictory theories, all of which supposedly rely on traditional economic models. Today, to provide some additional and much needed color, we once again revisit the topic of TARGET2, and this time we look at arguably the most critical question: what happens when the TARGET2 imbalance bubble ultimately pops. And here is where the true cost to Germans becomes apparent, because there is no such thing as a "borrowing from the future" free lunch. Which is precisely what TARGET2 does, only instead of a direct cost, the post-TARGET2 world will result in the now traditional indirect cost of all monetary experiments gone awry: runaway inflation.
As Goldman summarizes:
Who ultimately pays for TARGET2 losses? Higher inflation part of the bill
[T]he important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising net claims vis-à- vis the other Euro area central banks.
In other words, if Goldman sought to appease Germans' fears about the aftermath of providing what effectively equates to "costless" bailouts, in the form current account deficit funding for the PIIGS, by telling them the final cost may well be a tide of runaway inflation, one which may come far sooner than most expect, we are skeptical they have succeeded.
Full report from Goldman:
Assessing the financial risks of TARGET 2 for Germany
As Germany recorded current account surpluses from the early 2000s, its financial exposure to the rest of the world rose. While Germany’s net international investment position (NIIP) was close to zero at the turn of the century, it had risen sharply to close to €1trn by 2011. This significant rise in German net foreign asset ownership also necessarily implied an accumulation of the financial risks associated with these assets. However, both the ownership and composition of these net claims against the rest of the world have changed significantly over time: banks and other financial institutions have reduced their net holdings of foreign assets substantially since the start of the crisis in 2007, while there has been a sharp increase in the public sector’s foreign exposure.
The rise in the net foreign asset position of the public sector has taken place through two channels:
- The financial help provided to the Euro area periphery through the EFSF and—in the case of the first Greek programme—other government-owned institutions has led to a direct increase in financial exposure for the German government.
- The other, and more relevant channel in terms of the volumes involved, has been the Bundesbank’s TARGET2 claims against the Eurosystem.
It is thereby no coincidence that the increase in net foreign assets on the Bundesbank’s balance sheet roughly matches the decline seen on banks’ balance sheets. Thus, the TARGET2 imbalances, at least so far, have mainly replaced financial risk that was previously sitting on private-sector balance sheets.
Further movement of capital from the periphery to Germany—for example, as peripheral households transfer deposits to Germany—would imply additional, genuinely new external financial risk for Germany, reflected in a further rise in TARGET2 claims.
But it is important to bear in mind when assessing Germany’s external financial risk that, as a central bank, the Bundesbank’s ability to deal with financial losses incurred as a result of these exposures is of a different character to the ability of the private sector or government. In particular, the operational capacity of the Bundesbank would not necessarily be significantly impaired even if it were forced to run temporarily with significant negative equity.
A current account surplus implies more foreign assets
Throughout the 1980s, Germany recorded a rising current account surplus (see Chart 1). This surplus quickly turned into a deficit as the reunification boom led to a sharp increase in imports. It took until 2001 before this current account deficit was turned back into a surplus. The combination of weak domestic demand, a recovery in competitiveness and strong external demand then pushed the current account surplus to a record high of around 7.5% of GDP in 2007.
As a consequence of the growing current account surpluses recorded over the past ten years, Germany net international investment position (the difference between all foreign assets owned by the German private and government sector and German assets owned by foreigners) has increased sharply (see Chart 2). At the end of 2011 Germany’s NIIP stood at close to €1trn.
The assets that make up Germany’s NIIP include bonds (whether issued by governments or corporates), loans, stocks and foreign direct investment. But regardless of the specific characteristic of the underlying asset, they all also represent a financial risk to some degree, in the sense that the return on these assets is not certain—and could even be zero.
Changes in sectoral risk exposure to the periphery
The aggregate figures for the NIIP blur the significant differences that exist at the sectoral level. Chart 3 shows the NIIP broken down into different sectors, such as Monetary Financial Institutions (MFIs) (which are mostly commercial banks), non-financial corporates and private households, the government and the Bundesbank.
The chart illustrates three noteworthy points:
- Banks/MFIs have reduced their NIIP sharply. German banks’ NIIP rose from a negative -€300bn in the middle of 2000 to +€520bn by the end of 2008. Since then, their NIIP has declined to €170bn at the end of last year. Meanwhile, German banks’ gross credit claims against the periphery have declined from almost €600bn to around €300bn (Chart 4).
- Corporates and private households have seen their NIIP increase further during the crisis. Companies and private households represent the bulk of Germany’s NIIP. Roughly 60% of these assets (€700bn) are portfolio investments, 30% are direct investments, and 10% are lending and deposits held at foreign banks (Chart 5).
- Foreigners hold a significant share of Germany’s public debt. The German government sector (all levels, excluding Bundesbank) was indebted on a net basis vis-à-vis the rest of the world by more than €1trn at the end of last year.
Exposure to the periphery
Looking at Germany’s country-specific exposure, German net investment in peripheral economies stood at around €1trn at the beginning of 2012, the bulk of which is concentrated in Italy, Spain and Ireland (Chart 6 shows the net investment of all sectors vis-à-vis the countries in the periphery). Note, however, that these figures do not reflect the net claims of the Bundesbank vis-à-vis the Eurosystem due to TARGET2 imbalances. As a claim on the ECB rather than a specific country, these claims are not against a specific country and are therefore recordedas net investment into the Euro area.
Most German investment in the peripheral countries reflects ownership of companies or production facilities located there. Roughly a third of the net investment in the periphery is lending (Chart 7). Lastly, we take a look at bank lending to peripheral countries (Chart 4). While Germany’s overall financial exposure to the periphery has been broadly stable, banks have reduced it significantly since the beginning of the crisis.
Pulling all these data together, we can see a clear shift in the composition of Germany’s net foreign asset position: financial institutions have sharply reduced their exposure to the periphery , while the public sector has increased its claims significantly. The main channel through which this transfer of risk has taken place has been the TARGET2 system.
TARGET2 imbalances are on the rise
Commercial banks use the so-called TARGET2 system to facilitate money transfers across the Euro area. One crucial feature of TARGET2 is that claims between national central banks resulting from cross-border money flows between commercial banks are not settled. If, for example, a commercial bank in Greece wants to transfer money to a German bank, the Bank of Greece simply asks the Bundesbank to credit the account of the German commercial bank with that amount and at the same time debit the account of the Bank of Greece with the same amount. As a central bank, there is no funding required for the Bundesbank in this operation. The Bundesbank simply ‘prints’ the money it credits to the account of the German commercial bank.
Before the crisis, flows between the periphery and Germany were broadly balanced. Banks and nonfinancial corporates borrowed from German banks and companies in order to finance, in large part, the trade deficit the periphery held with Germany. This implied that money flowed from the periphery to Germany (to pay the bill for imports) and from Germany to the periphery (to provide a credit such that the bill could be paid). But as German banks reduced their lending to the periphery on account of concerns about counterparty risk (Chart 4), capital flows have become a one-way street. Consequently, the net claims of the Bundesbank against the Eurosystem have risen sharply (Chart 8).
What are the financial risks from TARGET2?
In assessing the financial risk stemming from the increase in the net claims of the Bundesbank against the Eurosystem—the TARGET2 imbalances—it is important to bear in mind that, at least so far, they mostly replace debt held by German banks. Put differently, the financial risk for the country as a whole has not changed significantly on the back of the rising net claims of the Bundesbank.
This may no longer be the case, however, once rising net claims reflect not only normal commercial and investment activities, but rather deposit flight from the periphery to Germany. So far, there is no real evidence that private households or companies are shifting their deposits to Germany in a significant way. But a genuine deposit flight from the periphery to Germany would lead to a significant increase in the Bundesbank’s net claims.
After all, peripheral private households alone hold more than €1.5trn of deposits. To be sure, the Bundesbank’s rising net claims vis-à-vis the Eurosystem would only represent a financial risk if a country were to leave the Euro area. Moreover, the losses of the Eurosystem are shared among all remaining countries. Thus, the financial risk for Germany has actually been reduced, as potential private losses have been replaced by losses that will be shared by the Eurosystem. However, in the event of a break-up of the Euro area, the losses from the Bundesbank’s net claims would materialise on the Bundesbank’s balance sheet alone.
Bundesbank operational effectiveness not endangered by potential losses
At this point, it is not possible to calculate the exact size of the Bundesbank’s potential losses in the event of a complete break-up of the Euro area. First, the amount would depend on how much further net claims rise. Second, it is not clear how much of these claims would need to be written down. Arguably, other national central banks/governments would have little incentive, or the economic means, to honour any of these liabilities. But depending on the circumstances of the break-up some mutual agreement about a haircut could be found.
That said, even though we do not know ex ante the size of the losses the Bundesbank faces, we can say that, in principle, these losses would not impair its ability to operate monetary policy. Put differently, it is not the case that the Bundesbank would first need to be recapitalised before it could once again conduct monetary policy at the national level. Indeed, there are several examples of central banks that have operated with negative equity and have been able to maintain price stability. The Bundesbank could, for example, simply insert a claim against the German government on the asset side of its balance sheet in order to maintain its balance sheet in balance in an accounting sense.
Who ultimately pays for TARGET2 losses? Higher inflation part of the bill
This does not mean that potential TARGET2 losses would not imply a significant challenge to the Bundesbank. Its first challenge would be to stabilise inflation expectations. Expectations about future price developments play a crucial role in the inflation process: if economic agents were to expect, for whatever reason, an increase in prices and adjust their economic decisions accordingly, expectations would become self-fulfilling. This is why central banks in general monitor inflation expectations carefully.
How would inflation expectations react if the Bundesbank were to incur significant losses and had to operate with negative equity? Again, there is no easy answer to this but, according to the so-called fiscal theory of the price level, the credibility of a central bank also depends on its solvency. The Bundesbank’s solvency would be questioned if the losses exceeded the net present value of its future income (seignorage). A backof-the-envelope calculation of this net present value suggests the Bundesbank has economic capital of around €2trn. Thus, the Bundesbank has significant capacity to absorb losses before endangering its ability to guarantee price stability.
There is also a more mechanical way of assessing the potential inflation risk stemming from Bundesbank losses on the back of the TARGET2 imbalances. These imbalances are the result of rising deposits on the balance sheets of German commercial banks. These deposits ultimately represent a claim on German GDP, as the holders of the deposits could spend the money sitting in their accounts. Another way to look at this is that rising deposits at German banks imply that monetary aggregates are rising in relation to the underlying German economy.
Whether these deposits would be inflationary or not would depend on several factors—not least how quickly these deposits are spent. But it is clear that the greater the amount of deposits held by non-residents after the breakup, the greater the potential inflationary risk. A high degree of uncertainty surrounds all of this and it is not possible to be more precise about the potential inflationary implications. But the important point in the context of the financial risk for Germany from the growing TARGET2 imbalances is that, in the event of a break-up of the Euro area, the price paid would not necessarily be in the form of a massive recapitalisation of the Bundesbank, which could endanger the solvency of the German government itself. Rather, it would come in the form of higher inflation, as Germany faced the financial costs of the Bundesbank’s rising net claims vis-à-vis the other Euro area central banks.