Europe’s trillion euro problem

Published in The National Business Review (Auckland), 14 July 2017

NBR Front Page 14 July 2017Some people fear rising sea levels, asteroids hitting the earth or global pandemics. It is easy to be scared of such threats because one can easily understand them.

With other risks, being appropriately scared is much harder. Some problems are just too complicated to cause the fear they deserve. Europe’s Target 2 system falls into this category.

Should you now ask yourself “Target what?” you are not alone. Many finance experts, bankers and journalists have never heard of it either – certainly not in this part of the world.

And yet, the European Central Bank’s clearing mechanism, Target 2, is a serious threat to global financial stability. The balances that have built up within it are so big they could wreck Europe’s central banks and its banking system.

Even though it is hard to understand what is going on, it is worth having a look.

To begin with, we should explain what Target 2 once was. It was a technical mechanism to facilitate transfers between European private and central banks. As such, it worked without a hitch before the beginning of the financial crisis in 2007-08.

Of course, there were economic imbalances in Europe well before the crisis occurred. Not least there were balance of payments deficits in some countries and surpluses in others. But as long as private capital flows into the deficit countries were available, there was no immediate problem.

That changed when markets started to question the health of especially Southern European economies and stopped lending to them. When that happened in the initial phases of the euro crisis, the balance of payments issues became acute – and Target 2 morphed into a system to plug the gaps.

Before the crisis, European central banks such as the German Bundesbank, the Banca d’Italia or the Banque de France had no claims or liabilities within the Target 2 system. Target 2 was basically a conduit.

In the euro crisis years, however, Target 2 became a de facto overdraft for the eurozone periphery. It allowed Southern Europe to continue importing more than it exported without having to find private capital to make up for the difference.

To do this, Target 2 created euros out of thin air in crisis countries. The central banks of the other eurozone countries, meanwhile, received corresponding claims.

For the Bundesbank, these claims peaked at €751 billion in August 2012 and then fell back to “just” €461 billion by December 2014. The reason for this fall was ECB President Mario Draghi. In mid-2012 he had reassured markets to do whatever it takes to save the euro. With that guarantee, capital could once again flow to the eurozone periphery.

Mr Draghi’s promise was enough to drive down the Target 2 balances for a while and shift the euro crisis off front pages. But just because the public no longer pays much attention to the problems of the eurozone does not mean that the crisis was over. The opposite is true.

In May this year, the Bundesbank reported Target 2 claims of €857 billion. The Bundesbank holds the largest chunk of Target 2 claims, equivalent to more than half the bank’s balance sheet and nearly eight times Germany’s gold reserves.

Other creditors are the central banks of Luxembourg, the Netherlands and Finland. In total, we are now looking at claims worth more than €1.2 trillion.

There are good reasons why over the past two-and-a-half years the Target 2 problem has become worse again, despite Mr Draghi’s earlier intervention.

However, it is no longer mainly a balance of payments issue that Target 2 is glossing over. That is only part of the problem because both Spain and Italy are in surplus (while Greece is still running a deficit). No, the real problem is a lack of trust in the health of the eurozone periphery’s banking system.

Italy just bailed out two regional banks, which is only the peak of a bad debt mountain. The problems of Italy’s banking system are well known.

In this situation, markets prefer the relative safety offered by Germany, Luxemburg, the Netherlands and Finland. The rise in these four countries’ Target 2 balances is thus a sign of capital flight.

As we are witnessing this dramatic development in the eurozone hardly anyone seems overly concerned. How is that possible?

Well, the first reason is that Target 2 is no asteroid or pandemic. We are talking about some obscure positions on central banks’ balance sheets that no ordinary person could make head or tail of. As such, you really need to follow European monetary policy closely to even understand the problem.

The second reason is even more cynical. As long as the eurozone survives, the Target 2 balances may be large but they do not do any immediate harm. Problems will only occur should one country ever decide to leave the eurozone.

There is just no plausible mechanism under which departing eurozone economy would settle its Target 2 liabilities with the others. The hypothetical sums on banks’ balance sheets would then evaporate, leaving them grossly under-capitalised.

Will this ever happen? Maybe not soon. Can Target 2 go on forever? Probably not. And is the eurozone crisis over? It never was.

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