Target2 balances:False discussion about an explosive euro topic

A breath-taking amount: The Deutsche Bundesbank’s Target2 balance shows a claim of almost EUR 1 billion against the European Central Bank (ECB). But what does this figure really mean? Do we need to be worried?

Since the crisis in the financial markets, Target2 balances have served as a sort of fever curve for the structural imbalances in the euro area. In the past few months, the Target2 balances of the various euro-area states have drifted ever wider apart. Since the beginning of this year, the Bundesbank’s claims against the ECB as central counterpart of the Target2 system have increased by around EUR 70 bn to the current level of around EUR 976 bn (level in June).

Besides Germany, Target2 surpluses are also run by Luxembourg, Finland and the Netherlands. While these are far smaller, they are nevertheless still significant. On the other hand, especially the central banks of the European periphery have piled up substantial liabilities to the euro system. Italy leads the field here with liabilities worth EUR 464 bn. Spain follows on its heels with a negative balance of EUR 393 bn (in May).

Basically, these growing Target2 balances reflect the fact that the periphery’s banking sector is increasingly dependent on central bank liquidity because of an inadequate inflow and excessive outflow of private capital (capital flight). Against this background, the development of the Target2 balances may be regarded as a crisis indicator for tensions in the European banks’ payments system.

But caution is needed here: this basic interpretation does not apply at the moment as the substantial increase in the Target2 balances in the last few years has been very heavily influenced by the ECB’s bond-purchasing programme. The increase in the positive Target balances in Germany, Finland, Luxembourg and the Netherlands is relatively closely correlated with the growth of the ECB’s bond portfolio.

One possible way in which the bond-purchasing program contributes to the widening of the gap between the Target2 balances is shown by the following example: if the Italian central bank buys Italian government bonds not from a domestic, but from a German commercial bank, then this would have a direct impact on the Target2 balances as the central bank liquidity is credited across the frontier. The Bundesbank would show a rising Target2 claim and the Italian central bank a higher Target2 liability.

Another factor influencing the Target2 balances is to be found in the bond purchases made by banks domiciled outside the euro area. In this case, most important for the development of the Target2 balances is via which national central bank the international business partner is linked to the Target2 system. If, for example, the international bank has an account at the Bundesbank, which is often the case because of Frankfurt’s importance as a financial centre, bond purchases by other central banks of the euro-system would lead to capital inflows at the Bundesbank, which would cause its Target2 claim to increase.

Finally, the Target2 balances are also drifting apart because of the different distribution of the central bank liquidity pumped into the market by the ECB and the place where the bond purchases are settled. It may be assumed that the pace at which the Target2 balances are drifting apart will slow in the future as the ECB will end its bond purchases at the end of the year.

On the dangers of the Target system for Germany: Basically, the Target2 balances are not a problem as long as the Monetary Union exists and the “deficit countries” remain members of the Union. However, even in the event that a deficit country were to leave the Monetary Union, this would still not have any consequences for the real economy. It would only be reflected in the central bank system and as regards the balance sheet technicalities would lead to a cash overhang, which has, however, already existed in practice for the last few years. The Bundesbank would also show a large balance sheet loss.

If this were settled by the German government, the national debt would increase correspondingly steeply. However, this loss need not necessarily be settled. If it is not settled, the Bundesbank’s equity capital becomes correspondingly negative. In my view, however, this would not be a cause of concern as the actual capital of the Bundesbank is the trust of the people. This would certainly not be shaken by such technical considerations. To sum up, it may be said that while one can talk about many technical difficulties, the essence of the Bundesbank, namely the trust of the people, will not be affected. So politically and economically the consequences would be manageable.

Apart from these technical considerations, the Target2 balances are, however, also a constant reminder that for political reasons countries have come together in the Monetary Union that were not really supposed to be linked by a single currency. The structural differences are too great and the governments in power do not have the will to change this permanently. In the medium term, this will increasingly call into question the cohesion of the euro area. The implementation of transfer systems, such as a joint deposit protection system, will not solve the problem for the countries running a deficit in the next few years but they would gain negotiating power, because once the transfer systems have been installed, the damage that would be caused by breaking up the Monetary Union would be far greater than it is today for the countries with a surplus in the Target system.

 

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