John Whittaker is an economist at Lancaster University, specializing in monetary policy. After an earlier career in business, he obtained a doctorate in nuclear physics before joining the academic world in the 1980s. His research and teaching experience include money and banking, macroeconomics, and financial economics, and he has published papers on alternative monetary regimes and mathematical economics. His current interests are sovereign debt problems in the eurozone, and the response of policy and regulation to the financial crisis and the recession. From 2004 to 2009 he was a Member of the European Parliament for the North West of England, representing the UK Independence Party.
In June 2011 Hans-Werner Sinn, a leading German economist, picked up the subject of intra-eurosystem debts that you had written about in March, seeing these debts as a stealth bailout of enormous proportions. That in turn gave rise to an intense debate over the significance of these debts. Were you surprised?
Yes, because Professor Sinn made some fundamental errors in his analysis. My paper sets out the nature of the financial flows between the national central banks (NCBs) and between the NCBs and the European Central Bank (ECB), which are reflected in the eurozone settlement mechanism, called TARGET2. However, in his argument he miscasts the role of the TARGET2 mechanism. He makes two major claims: first, that the TARGET2 figures—which show that by December 2010 the Bundesbank had lent €325 billion to other NCBs—somehow provide evidence that the Bundesbank’s lending to NCBs in the peripheral euro countries is “crowding out” its lending to German banks, starving them of credit. That claim is wrong. The Bundesbank’s claim on the eurosystem does not imply a shortage of credit in Germany.
Second, he claims that the increases in the TARGET2 liabilities of the NCBs in countries on the euro area periphery (EAP) are financing EAP current account deficits. But cross-border trade is only one cause of financial flows—they are also caused by bank transfers that are unrelated to trade, and there is in fact little correlation between changes in TARGET2 debt and the balance of payments for a particular country. Whatever the cause, it is hard to characterize TARGET2 debts as a “stealth bailout” conducted by Germany via the Bundesbank.
What is the status of the TARGET2 debts? Do they have real-world implications or are they “merely” accounting figures?
The TARGET2 debts of the EAP countries are just as real as the debts to the European Union/IMF that these countries have taken on under their official “bailouts.” But they are cheaper. In the Irish case, for example, TARGET2 debts currently carry an interest rate of 1.5%, whereas the rate for the official bailout of €67 billion is about 5.8%—a point we will pick up later.
Hence, Sinn is on the right track in recognizing that the TARGET2 debt that is being run up by Ireland and other EAP countries exposes the Bundesbank, and therefore Germany, to a nontrivial risk of losses, together with all the other countries that fund the ECB. However, it is important to realize that TARGET2 flows are an essential mechanism in the operation of the eurosystem. There is no way of arbitrarily “controlling” TARGET2 balances by, say, placing a debt ceiling on any one country’s TARGET2 balance—which, incidentally, is one of Sinn’s suggestions.
Would you explain why there can be no limiting of TARGET2 balances, and the nature of the risks associated with those balances?
We need to begin with a brief account of how interbank lending in the eurosystem works. If an Irish depositor moves funds from an Irish bank to a German bank, for instance, that gives rise to a debt between the two banks. In normal circumstances, this would be cleared through the private interbank settlement system, which is run by organizations such as LCH Clearnet in the United Kingdom and Euroclear in Europe. These systems “net out” the position between the various banks and provide a settlement system for fund transfers between the banks.
However, Irish banks are currently closed out of the interbank market, which means that they have to make up for the loss of the deposit by borrowing from the Central Bank of Ireland (CBI). In turn, the CBI acquires a debt to the Bundesbank, the central bank of Germany, while the German bank receiving the deposit acquires a claim on the Bundesbank—which is treated as a reduction in the amount of borrowing it requires from the Bundesbank. To call this a stealth bailout by the Bundesbank is risible. A private claim (the deposit) has gone from Ireland to Germany; a public claim has gone the other way.
The CBI has been “allowed” to increase its debt, but Ireland does not see any funds that it could do anything with. What has happened is that an Irish depositor, seeing the desperate position of Irish banks, has shifted his/her money to a “safer” German bank, and in the process the Irish TARGET2 debt balance has increased. Exactly the same flows take place every time an Irish resident buys German goods. Goods travel to Ireland, and the CBI’s TARGET2 debt increases while the Bundesbank’s TARGET2 claim increases.
It is important to note that within the eurozone there is no mechanism to stop an Irish person buying German goods or to stop Irish depositors moving their euros out of an Irish bank and into a German bank. So it follows that there is also no way of limiting TARGET2 debts. These debts will continue to climb as long as funds keep flowing out of Ireland and Irish imports exceed exports while Irish banks are shut out of interbank borrowing.
Through this process, by December 2010 the Bundesbank had built up claims on other NCBs of €325.5 billion, Luxembourg had built up claims of €68 billion, the Netherlands claims of €40.2 billion, and so on, while Ireland had liabilities to other NCBs of €145.2 billion, Greece had liabilities of €87.1 billion, Portugal €59.9 billion, and Spain €50.9 billion. The complete list nets out to zero, as it must. The overall TARGET2 debt rose by about seven times between the end of 2004 and the end of 2010, although it has fallen slightly since then.
What are the risks associated with TARGET2 debts?
Now we come to the interesting part. The Bundesbank is doing most of the lending, with 70% of the TARGET2 credit outstanding, while the CBI is the biggest borrower. However, the Bundesbank is not at risk for all of this. Any losses on TARGET2 lending would probably be shared in proportion to the NCBs’ “capital keys,” which are the shares of the NCBs in the capital of the ECB. The capital key of the Bundesbank is 27%, so the Bundesbank—and ultimately the German taxpayer—is at risk for 27% of the total TARGET2 lending of €457 billion, i.e. €123 billion.
But the ECB has to balance this against the risk of calling a halt to further rises in EAP debts. If, for instance, the ECB declared that Irish government debt was no longer acceptable as collateral for CBI lending, then the Irish banks would no longer be able to honor demands for foreign payments—a German bank would not be able to clear a check drawn on an Irish bank. Then, unless the CBI were somehow able to find eligible collateral from elsewhere, that would be tantamount to the ECB expelling Ireland from the eurozone, and we are then in uncharted territory.
There is a great deal of interesting work that remains to be done to map out what would happen in those circumstances. The departure of an EU member need not necessarily be chaotic. We might look, for instance, at the precedent of the orderly separation of the currencies of Slovakia and the Czech Republic.
If all eurozone governments agreed that a member should leave, forward planning might make for a smoother departure. However, the major problem would be to stop a capital flight from the country concerned if people believed—as would almost certainly be the case with Greece—that the reestablished national currency would suffer major depreciation.
The CBI has been providing emergency liquidity to Irish banks to keep them afloat. How does this work?
The normal method by which an NCB lends to its banks is via repos—effectively, loans against collateral approved by the ECB. But because Irish banks ran short of eligible collateral, the CBI has made increasing use of emergency liquidity assistance (ELA). ELA is overnight lending which the CBI undertakes on its own initiative, outside the ECB’s rules on collateral. And although it is supposed to be used only in exceptional circumstances and for short periods, ELA by the CBI has been in continuous use for the last 18 months, and it amounted to €50 billion at the end of 2010.
There is a second way in which Irish banks have been borrowing from the CBI while avoiding the ECB’s usual collateral rules. They have been issuing unsecured debt to themselves, which is then given an eligible liabilities guarantee (ELG) by the Irish government. The ECB has deemed that this guarantee enhances the credit of these Irish banks sufficiently to make the debt acceptable as collateral for ordinary repo funding. In all, some €27 billion of Irish bank debt was accorded ELG status by the end of 2010.
So the Irish banks are as near bankrupt as they can get, but because the Irish government—which does not have the money to cover their debts—issues a guarantee, does that makes their debt good collateral for the ECB?
The ECB could, of course, tighten its collateral standards, and its governing council is empowered to order the CBI to cease ELA. However, the burden would then fall directly on the Irish government since it has guaranteed its banks’ liabilities, and it is in no position to bear this. If the Irish government assumed all its banks’ current debt to the eurosystem, this would double Ireland’s gross debt to GDP ratio to a truly unsustainable 180%.
The bottom line is that the ECB has to condone the continuing provision of “liquidity” to Irish banks—these schemes are just ways in which the ECB tries to maintain the fiction that it is still applying collateral standards. If the ECB ruled that the CBI must no longer provide its banks with liquidity, the banks could no longer stay in business.
Of course, the CBI debt to the eurosystem will fall as the Irish National Asset Management Agency (NAMA)—the body that has taken over the foreign assets of Irish banks as part of the Irish government’s bailout of those banks—succeeds in disposing of those assets. However, NAMA would rather avoid disposing of those assets at “fire sale” prices, so this winding-down of the debt will take time. In the meantime, the CBI must continue to fund them by whatever means can be devised to bypass the ECB’s already diluted collateral requirements. In turn, other NCBs find themselves lending to the CBI. It is likely that this state of affairs, under which the eurosystem is supporting Ireland, will continue for some time to come.
The ECB may not like it, but unlimited sharing of NCB liabilities is a necessary condition for the continued existence of the euro as a multinational currency. If Ireland had retained its own currency but fixed it to the euro, the outflow of foreign (euro) assets caused by the banking crisis would long ago have caused a devaluation of the Irish currency. However, with the single currency, the liabilities of any NCB (euro currency and bank reserves) are indistinguishable from the liabilities of other NCBs. Thus the CBI can freely incur “foreign” liabilities (i.e. within the eurosystem), which enables the “fix” of its own euros against the euros of other NCBs to be upheld.
For all Germany’s fear of becoming locked into providing permanent support for the Irish and others through the official IMF/EU bailouts, the irony is that it is already providing involuntary “bailouts” via the eurosystem. In the Irish case, this is both larger than the official bailout (€145 billion as against €67 billion) and much cheaper (1.5% interest as against 5.8%). And the ECB has progressively had to reduce its collateral standards, for instance, by changing its rules to continue accepting Greek and Irish government debt after this was downgraded to “speculative.” The ECB’s rules on collateral are effectively being driven by the financing needs of the weakest banks.
This creates its own moral hazard problem. So long as banks have access to cheap funding from the eurosystem, they are less inclined to seek funds elsewhere. Likewise, the Irish and Greek governments, having guaranteed their banks’ liabilities, prefer that support comes from the eurosystem rather than from themselves.
The ECB’s only remedy against this is to try to make debtor governments uncomfortable by reminding them that its attitude to collateral and to their debts might change. But repeated threats by the ECB to stop the flow of liquidity to banks are no longer seen as credible.