Palm Beach, FL 2/15/12 (StreetBeat) -- Greece owes more money than it can repay. There is some measure of concern that the story is the same for Portugal and Ireland; maybe even Spain, possibly Italy if things don’t go according to Hoyle. While the focus has been on the sovereign debt from these countries, they also have other liabilities that some people fear will not be made whole. Additionally there is a line of thinking that the growth and financing of these other liabilities is an indication of a balance of payments crisis in European central banking that could shake the euro zone to its foundation. There are differing opinions on this topic, but it is probably better to be aware of its existence, just in case it becomes a flash point.Each country that uses the euro as its currency has its own National Central Bank (NCB). The NCBs interact with their domestic banking system and interconnect with other countries’ banking systems through the European Central Bank (ECB). In order to facilitate cross border payments the euro zone has a transaction settlement system. This system is known as TARGET2; it stands for Trans-European Automated Real-time Gross settlement Express Transfer system. The 2 indicates a change to the original TARGET system in November 2007.
TARGET2 is not something that should be noticed; it is the plumbing, not the nice fixtures. TARGET2 pipes have not become clogged, nor has a leak been sprung, the system is functioning. But the flow of payments within this system has become significantly imbalanced and as a result is now the source of great consternation, especially for a well regarded German economist, because of its implications for ECB monetary policy in general and the well being of the Bundesbank in particular.
When there is a cross border transaction in the euro zone a TARGET balance is created, explains Hans-Werner Sinn, the very concerned President of Germany’s IFO Economic Research Institute, in his paper called Target Loans, Current Account Balances and Capital Flow: the ECB’s Rescue Facility. For example, “a Greek transportation company buys a German truck. With the bank transfer the money flows to the Greek central bank and ceases to circulate in Greece: i.e. it is destroyed there. Conversely, the Bundesbank must carry out the transfer and to do this it creates new money that flows to the manufacturer via its commercial bank. A TARGET liability is assigned to the Greek central bank on the amount of the transfer request vis-à-vis the ECB, and conversely the Bundesbank receives a TARGET claim on the ECB.” From the beginning of the use of the euro currency and this transfer system the TARGET accounts were roughly in balance throughout the system. The Bundesbank for instance was almost as often a debtor in the system as it was a creditor; in the early years from 1999 up to early 2007 the German central bank rarely had a TARGET balance in excess of EU30 billion on either side of the ledger; and that is how it was envisioned. “When the TARGET system was established, it was assumed that the balances would be insignificant,” points out Sinn in the paper I cited above. “As insiders have reported, the belief prevailed at the time that the balances would virtually net out daily, and it was thus not considered necessary to put a cap on them. They were to have the character of short-term checking account credits to smooth out the peaks in monetary transactions.” It was not considered to be necessary to zero out the balances in this system on a regular schedule because the regular flow of funds would periodically zero out themselves; the NCB quid pro quo was all that was assumed to be needed, a huge imbalance was not imagined.
But once the global economy hit the skids in late 2007 the TARGET system began to take on a different form as the Bundesbank began to accumulate credits on the ECB. Not that anyone noticed right away. Since the ECB credits and liabilities in the TARGET system always net out to zero, there was nothing to seen on their balance sheet to signal imbalance. In order to take note of the lopsided situation it is necessary to find the data on the individual NCB balance sheets; the Bundesbank, for instance, identifies the TARGET balance as EU8148.
As of January 2007 the Bundesbank’s TARGET balance was a EU13.0 billion credit; by the end of that year the credit was EU71 billion. When the Greek budget fiasco first came to light at the end of 2009 the Bundesbank TARGET credit balance had grown to EU178 billion. As of last month the credit was an all-time high of EU498 billion. It should be noted that one of the key reasons for the growth of the Bundesbank balances is that private citizens in the troubled countries have been transferring their bank accounts out of their own country and into Germany, in order to prevent a surprise return to the Drachma, Punt or Escudo suddenly reducing their savings.
While the Bundesbank has ECB credits, the other side of the ECB’s ledger contains the liabilities for a corresponding total in the accounts of the central banks of Ireland, Greece, Portugal, Spain and beginning in the middle of last year, Italy. The Netherlands finds itself collecting ECB credits along with the Bundesbank, but in much smaller quantities than the Germans; the rest of the euro zone is much closer to balance than the countries I have mentioned here. It can be said, and the IFO’s Sinn does, that this essentially creates a Bundesbank loan to the ECB for the amount of the TARGET credit; a loan that is then passed along to the PIIGS.
It can also be said that if any of these countries were to leave the euro zone it would be the Bundesbank that is on the hook for the loan, not the ECB. While it is true that should Greece, et al, hit the road that Germany would officially be liable for only 27% of the total left unpaid, Sinn is not so sure a euro zone in disarray would be in a position to honor that commitment.
Sinn also figures that the TARGET imbalances are an indication that the NCBs of the deficit countries have printed money to cover their imbalances. His assumption therefore is that a transfer union already exists and threatens to get bigger. On the one hand Sinn is concerned that Bundesbank will not get paid in full on its de facto loans to the euro zone banking system. But on the other hand he is concerned that the imbalances will grow ever larger unless the Bundesbank draws a line in the sand. His IFO group issued a declaration last October saying that Germany should insist on radical changes in the current monetary regime, including the payment of TARGET system debts, or that his country should leave the currency zone if their suggestions are not adopted.
While the IFO opinion may not be widely held in official circles in Germany, it likely has some constituents, maybe even some quiet supporters at the Bundesbank. Officially of course Sinn’s opinion and research on the matter are at the very least inconvenient for European central bankers. When he first broached the matter early last year the Bundesbank pushed back; they said the imbalances in the TARGET system were inconsequential, a reflection of the times and something that would eventually work itself out. The ECB said similar things when they addressed the issue in their October 2011 Monthly Bulletin after Sinn persisted with his argument. Even the New York Fed chimed in with an essay on the topic in December in the Liberty Street Economics publication, reiterating the “move along, nothing to see here” previously expressed by the European bankers.
It just seems to me that if you hear the term TARGET2 being used in anger by a market participant, it may be something you want to pay attention to.
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