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Europe’s hidden doomsday machine

Published in Business Spectator (Melbourne), 22 November 2011

How many crises are there in Europe? First, there is a sovereign debt crisis, which is plain to see just looking at bond markets. Second, there is the crisis of competitiveness in European periphery countries, which is exacerbated by their membership of the monetary union. Third, there is a crisis of Europe’s banking system, which desperately needs recapitalisation.

But there is a fourth European crisis that has so far escaped the attention even of many professional observers. And yet, this fourth and largely unknown crisis has the potential to overshadow all other crises. It is Europe’s escalating balance of payments crisis.

Europe’s countries have established a clearing mechanism to connect their banking systems. This ‘Trans-European Automated Real-time Gross Settlement Express Transfer System’ – or in short TARGET 2 – is meant to facilitate bank transfers across all EU member states (with the notable exceptions of the UK and Sweden). In ordinary times, Target would have been a technical tool without political implications. But times in Europe are not ordinary, and so over the past four years Target has become a potential time bomb for Europe’s financial system.

Since the beginning of the financial crisis interbank lending from core to periphery European countries has all but dried up. At the same time, periphery countries have experienced massive capital flight out of their countries. On top of that, there are trade deficits in European periphery countries which need to be financed by capital imports.

All three factors combined have triggered a European balance of payments crisis under the Target system. Put simply, central banks in surplus countries have to fill the gap caused by capital flight and trade imbalances because private capital is no longer available to do just that.

In this way, central banks from the healthier core of the eurozone are now sitting on enormous amounts of claims against the euro system. The German Bundesbank as the biggest lender has so far accumulated claims totalling more than €460 billion (approximately $615 billion). This sum is more than twice the guarantees given by the German government to the European rescue fund EFSF, for which the German parliament, after a long discussion, had only provided the comparatively modest sum of €211 billion.

The only other major creditors within the euro system are Luxembourg, the Netherlands and Finland, whereas all other eurozone countries are net debtors within Target.

Are these enormous Bundesbank claims against most of the rest of Europe a problem? Or are they just an accounting technicality with no serious consequences? It depends not only on who you ask, but it also matters how the euro crisis develops in the long run.

The greatest critic of Germany’s exposure to Target loans is Hans-Werner Sinn, president of Munich’s Ifo research institute. According to Professor Sinn, Germany is effectively financing the trade imbalances in the eurozone. His argument goes like this: countries like Greece or Italy import more than they export, without being able to borrow to make up for the difference. What they do instead is run the (virtual) printing presses and transfer the freshly printed euros to Germany. In this way, Sinn argues, the Target system is being abused to maintain trade deficits which should have been eliminated in the crisis. He also believes that this process has restricted credit availability within Germany as most of the newly created central bank money is concentrated on the euro periphery.

The controversy over the balance of payments crisis has raged mainly in German academic circles for some time now. Not least the Bundesbank and the European Central Bank have vehemently defended the Target mechanism against Sinn’s claims. To them the Target imbalances are just a symptom of the euro crisis, not a crisis in itself. The imbalances within the system cancel each other out and would eventually return to normal levels once the crisis is over. In any case, the ability of Germany’s commercial banks to lend would not be limited in any way. The only thing to change is the way in which German banks refinance themselves, either via deposits or through the Bundesbank. But all of these defences ignore a more unpleasant long-term question.

A few weeks ago the Council of Economic Advisers joined the debate in its annual report. The German government’s experts concluded that not all of the Target imbalances are the results of trade imbalances. Fair enough, but not even Sinn had claimed that. The Council also confirms that credit restrictions should not be expected. It then maintains that there is no technical limit to Target balances. However, there may come a day when Germany’s commercial banking sector turns from a net debtor of the Bundesbank to a net creditor. This would require some financial engineering on behalf of the ECB to avoid a zero interest rate.

So is everything fine with Target after all? Not quite. In its final paragraph on the Target problem, the Council dryly comments that in case of a default of any debtor nation, their Target balances would have to be written off by other eurozone countries according to their share of the ECB’s subscribed capital. In the German case this share is 27 per cent. In plain language: If, say, Greece defaulted, its negative €97 billion Target balance would lead to a Bundesbank loss of €26.2 billion. Ultimately, German taxpayers would then have to recapitalise their central bank.

Unfortunately, this is not even the worst case scenario. The German share of potential writedowns increases with every country departing from the eurozone. If more countries left without being able (or willing?) to balance their Target books, Germany would take even higher losses. Conversely, should Germany one day decide that it wishes to leave the euro behind to introduce its new Deutschmark, the chances are close to zero that other European countries would voluntarily settle their half a trillion euro bill with Germany.

It now looks as if for the past four years of the financial crisis Germany has effectively kept the trade imbalances party going in the euro periphery countries. But when the party is over, Germany will be sitting on enormous claims against these other countries, which will be effectively worthless.

What was once meant as a technical tool to facilitate bank transfers has become a doomsday machine. Worse still, Target has cemented trade imbalances within Europe that should have been corrected during the financial crisis. The Germans have also implicitly subsidised banks in periphery countries, which should have been liquidated when they could no longer recapitalise themselves.

For Europe there is no easy way out of this balance of payments crisis. The Target debtor countries will resist any restrictions on central bank credit, desirable as they are. On the other hand, a creditor exit from the system would finally reveal to the creditor public the amount of implicit subsidies given to the euro periphery (without any debates, let alone a democratic mandate).

What Europe is still discussing and Germany is vehemently resisting – the transformation into a fiscal liability union – has long been achieved through the Target backdoor. Brace yourself for the day when Europe finally wakes up to its forgotten fourth crisis.

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