The ECB must reform Target2 to make it sustainable

When and how will the European Central Bank (ECB) reform Target2, its unsustainable international payment system? The Deutsche Bundesbank credit balance recently set a new record of around €843.4 billion ($948.9 billion), with the combined debits of the Bank of Italy and the Bank of Spain almost the same figure. Eventual reforms to reassure creditors could well upset bank funding and government bond markets in peripheral eurozone countries. But the root cause of problems lies elsewhere. The fundamental issue is Germany’s huge international financing gap – a massive current account surplus and strong private capital inflows into the country that exceed the foreign investments that Germans would find attractive and safe.

The international financing gap in 2011/12, when Target2 was last in the news, was the opposite. It was the massive current account deficit of Greece combined with the flight of private capital that caused imbalances to swell. Loans from eurozone central banks to the Bank of Greece under Target2 rose to exceed €100 billion – dwarfing International Monetary Fund, European Union and other official financing sources.

Germany’s international financing gap arises because private investors cannot find enough safe and attractive external assets to recycle the inflows from the country’s quasi-permanent current account surplus and from foreign investments in Germany. Currency appreciation – the classic adjustment mechanism in such circumstances – cannot take place because of the common currency. And the interest rate and balance sheet policies of the ECB (rightly expansionary, given weak demand and low inflation in the eurozone as a whole) have led to a sizeable real depreciation of the euro.

This financing predicament creates an excess of funds flowing into German banks. This is not new. Before the global financial crisis, the combination of rising household savings and weak demand for domestic loans (as domestic investment demand remained very low by historical standards) meant that German banks had more funds than they could place at home. So they lent their surplus funds through the interbank market (uncollateralised) to banks in peripheral eurozone countries, notably in Spain and Ireland. Others invested in highly rated securitised products backed by US subprime and other assets. Because the current account surplus was offset by private-sector capital outflows, the outstanding Target2 balances remained small.

Neither strategy gave the German banks the safe international assets they had sought. Subsequent losses during the global and eurozone financial crises instilled much greater caution in the banks and their regulators about their international investments. It became evident to both banks and their regulator that it would be much safer for German banks to deposit their surplus funds with the Bundesbank.

The international financing gap was then closed by uncollateralised lending by the Bundesbank, through the Target2 payment system, to other eurozone central banks. What is ostensibly a payment system has become a mechanism for the official financing of structural balance-of-payments gaps of ever greater size. The net balances emerging from huge two-way flows, not settled by debtors transferring assets to creditors (as under a normal payment system), simply led to the automatic creation of a claim of the creditor central bank on the debtor central bank. Yet no explicit government decision has approved lending on such a scale. Moreover, under the full allotment policy, the Eurosystem imposes no direct limits on how much a national central bank can borrow. Nor does the ECB take collateral on the Target2 debts of national central banks.  

Unlike the case of Greece, both Italy and Spain have current account surpluses… These large balances … reflect how easily Italian and Spanish banks have been able to fund themselves by posting a form of collateral that they have in abundance – their own governments’ bonds

The underlying positions of the debit countries are quite different than in 2011/12. Unlike the case of Greece, both Italy and Spain have current account surpluses. Nor is the link to the cross-country pattern of sovereign risk as strong as it was in the earlier crisis. These large balances instead reflect how easily Italian and Spanish banks have been able to fund themselves by posting a form of collateral that they have in abundance – their own governments’ bonds.

One reason for such large credit and debit positions is that international financial firms continue to protect themselves from a breakdown of the euro. Since the euro’s existential crisis of 2011/12, the routine response of those in international banks and global companies seeking to protect themselves in the event of a breakdown of the euro has been to place their euro cash with banks based in Germany (and in Luxembourg and a few others) and ensure their short-term euro liabilities are in the periphery. For example, banks of all nationalities that sell eurozone government bonds to the national central banks under quantitative easing will tend to deposit the cash proceeds with banks based in Germany. One estimate is that 60% of all such purchases are conducted through banks that connect to Target2 via the Bundesbank.

There are two reasons why banks in Italy and Spain borrow heavily from their central banks. One is that their credit standing is comparatively low, given the high level of non-performing loans and the uncertain value of their property collateral. This makes it more expensive to fund themselves using cross-border interbank or bond markets. A second reason is that such banks may not be able to use the surplus liquidity generated by their own affiliates in other European countries. Host-country regulators often require such affiliates to keep enough cash to meet local withdrawals. Interbank markets in the eurozone are fragmented because the credit quality of banks in different countries is variable and uncertain, and regulators in ‘strong’ countries insist that foreign banks from ‘weaker’ countries keep sufficient liquid assets in their host jurisdictions.

Risk creation

Large outstanding balances that have become quasi-permanent create risks. If a country with a large Target2 debt leaves the euro, its central bank is unlikely to be able to repay this debt immediately. But there is also a less extreme risk: the failure of an Italian or Spanish bank with large short-term debts to its central bank. The hope is that the repurchase agreements in place will ensure the central bank suffers no loss when a commercial bank fails. But other creditors might seek alternative outcomes. For political and legal reasons, settling issues related to the collateral posted by the failed bank would take time. What would happen to Target2 balances in the meantime? Would other central banks use the crisis to suddenly tighten financing arrangements under Target2? The danger with all unsustainable financing arrangements is that they get corrected in a crisis, and not necessarily with due care.

At some point, the Bundesbank, as the main creditor central bank, might seek reforms of Target2. In most international financial crises, creditor countries use their political power to minimise any loss in the value of their external assets.

Placing some collateral with the ECB, rather than with the national central bank, could alter outcomes in the event of a bank restructuring. A more draconian step would be to define as eligible collateral only government bonds issued by creditor countries or by European supranational bodies

Many options could be considered. The current full allotment policy of the Eurosystem – where a bank with eligible collateral can borrow as much as it likes – could be reviewed. Another would be to impose interest rate penalties on central banks with debit balances beyond a certain threshold. Collateral policies might also be changed. Placing some collateral with the ECB, rather than with the national central bank, could alter outcomes in the event of a bank restructuring. A more draconian step would be to define as eligible collateral only government bonds issued by creditor countries or by European supranational bodies. Target2 would then resemble something similar to a gold standard, compelling debtors to buy bonds counted as eligible collateral and sell the bonds of their own government. Creditors might feel more assured that their assets are truly safe.

This assurance, however, would prove illusory. Toughening financing for debtors would not work unless supported by other policies to deal with the root cause of the explosion in Target2 balances. This is a result of the size of Germany’ current account surplus, which is so large that it cannot be fully offset by counterpart private capital outflows into foreign investments that German investors (or banks) would find safe and attractive. The 2011/12 eurozone crisis was at its root a balance-of-payments crisis. The deflationary policies that followed this put all the adjustment burden on debtors. Reform of Target2 should not make the same mistake.