TARGET balances of National Central Banks in the Eurosystem. Timo Wollmershäuser Ifo Institute for Economic Research and University of Munich

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1 TARGET balances of National Central Banks in the Eurosystem Timo Wollmershäuser Ifo Institute for Economic Research and University of Munich

2 TARGET balances the facts Germany: 450 bn (Sep.) Spain: 83 bn (Sep) Italy: 52 bn (Aug) Greece: 96 bn (Aug) Portugal: 61 bn (Jul) Ireland: 126 bn (Jul) chronology almost balances before the outbreak of the crisis significant increase from 2008 on pause from mid 2010 to mid 2011 sharp increase since June 2011

3 TARGET balances the facts TARGET claims of the Deutsche Bundesbank vis àvis the Eurosystem are equal to the TARGET liabilities of the National Central Bank in the GIPS countries

4 TARGET balances how they TARGET is an acronym emerge stands for Trans European Automated Real Time Gross Settlement Express Transfer refers to the European transaction settlement system through which the commercial banks of one country make payments to the commercial banks of another country

5 TARGET balances how they emerge no TARGET balances before the crisis current account transactions and financial account transactions cancel out each other payments from country A to country B (A s imports of goods from B) are mostly offset by payments of country B to country A (B s portfolio investment to A)

6 TARGET balances how they emerge significant TARGET balances only build up during the crisis net private capital inflows into periphery countries ceased (balance of payments crisis ) private capital stopped flowing into periphery countries (interbank lending ceased) private capital fled from periphery countries (deposits at Greek banks fell by 50 bn ) public capital stepped in capital imports through the Eurosystem

7 TARGET balances how they emerge mechanism behind TARGET balances A: Initial Central Bank Balance Sheets Gold and foreign reserves 200 Deutsche Bundesbank 400 Currency Gold and foreign reserves 200 Central Bank of GIPS 400 Currency Refinancing operations Deposits Refinancing operations Deposits B: Export of Goods from Germany to GIPS: Central Bank Balance Sheets after Payment from GIPS MFI to German MFI Gold and foreign reserves 200 Deutsche Bundesbank 400 Currency Gold and foreign reserves 200 Central Bank of GIPS 400 Currency Refinancing operations 400 TARGET (G-CB) Deposits Refinancing operations Deposits 100 TARGET (Bundesbank)

8 TARGET balances how they emerge mechanism behind TARGET balances A GIPS firm imports a good from Germany and makes a corresponding payment of 100 euros from its GIPS commercial bank to the German commercial bank of the exporter. For the settlement of the current account transaction the commercial banks use the TARGET system. 1. The deposits of the GIPS commercial bank at the Central Bank of GIPS fall by 100 euros. 2. The 100 euros are debited from the TARGET account of the Central Bank of GIPS and credited to the TARGET account of the Deutsche Bundesbank. 3. After the payment has been transferred through the TARGET system, the deposits of the German commercial bank at the Deutsche Bundesbank rise by the same amount. Supply of central bank money rises in Germany and falls in GIPS, but remains constant in the Eurosystem as a whole.

9 TARGET balances how they emerge mechanism behind TARGET balances However, the demand for central bank money in both countries remains unchanged! German banks don t need the additional amount of central bank money. GIPS banks have to replace the drained central bank money. The bank s demand for central bank money is determined by mostly domestic factors (payment habits, economic activity). German banks reduce their refinancing operations by 100 euros, GIPS banks increase it by this amount C: Central Bank Balance Sheets during the Crisis Deutsche Bundesbank Central Bank of GIPS Gold and foreign reserves Currency Gold and foreign reserves Currency Refinancing operations 300 TARGET (G-CB) Deposits Refinancing operations Deposits 100 TARGET (Bundesbank)

10 TARGET balances how they emerge Three testable hypotheses TARGET does not change the distribution of the monetary base in the Eurosystem TARGET changes the composition of the monetary base in the Eurosystem TARGET is a mechanism to finance current account deficits

11 TARGET balances some evidence Evidence I: TARGET does not change the distribution of the monetary base in the Eurosystem no excessive extension of the monetary base in Germany crowding out of refinancing credits in Germany by central bank money created in GIPS countries no excessive reduction of the monetary base in the GIPS but an excessive demand for refinancing credits in the GIPS most of the monetary base created in the GIPS is transferred to Germany

12 TARGET balances some evidence Evidence II: TARGET changes the composition of the monetary base in the Eurosystem euros are excessively created by GIPS central banks only 5% of the refinancing operations of the Eurosystem are currently executed by the Bundesbank almost two thirds are executed by the GIPS central banks (although they only account for 18% of euro area GDP)

13 TARGET balances some evidence Evidence I and II together the monetary base is in line with fundamentals 17% of the total monetary base of the euro area is circulating in the GIPS (they account for 18% of euro area GDP) euros are excessively created by GIPS central banks almost half of the total monetary base of the euro area is created in the GIPS this central bank money is transferred via the TARGET system to N GIPS (Germany)

14 TARGET balances some evidence Evidence III: TARGET is a mechanism to finance current account deficits Current account deficits one of the root causes of the crisis still persist even after 3 years of deep recession ( ) are not much lower than in 2005, a boom year

15 TARGET balances some evidence Evidence III: TARGET is a mechanism to finance current account deficits Current account deficits one of the root causes of the crisis still persist even after 3 years of deep recession ( ) are not much lower than in 2005, a boom year for 2011 we only have data for the first two quarters

16 TARGET balances some evidence Evidence III: TARGET is a mechanism to finance current account deficits since the end of 2007 a large part of the current account deficits of the GIPS was TARGET financed Current account balance Balance of Payments Private financial account balance Public financial account balance (TARGET balance and other public credit) in the German balance of payments: Financial transactions with nonresidents / Other investment abroad / Bank deposits / Bundesbank

17 TARGET balances a risk? For two reasons: 1. TARGET balances are public cross country loans to periphery countries 2. TARGET balances reflect changes the composition of the monetary base in the Eurosystem

18 TARGET balances a risk? TARGET balances are public cross country loans to periphery countries as such they are used to finance current account deficits internal adjustment processes are postponed as such they are subject to risk that the debtor will not be able to repay the loan what if Greece quits the euro? the actual liability of the Greek CB is 96 bn similar to a special form of jointly and proportionately guaranteed Eurobonds, in terms of liability, the international payment flows, the credit relations among the countries and the transfer of resources actually involved.

19 TARGET balances a risk? TARGET balances are public cross country loans to periphery countries not just an indicator of intra Eurosystem divergences a mechanism that provides assistance to countries with external financing needs and liquidity constraints parallels with the Bretton Woods system US (=GIPS) was issuing the reserve currency other countries had to sterilize the inflow of foreign central bank money a policy measure whose design is debatable for example limit the amount of the balances

20 TARGET balances a risk? TARGET balances are public cross country loans to periphery countries I am convinced that the designer of the TARGET system did not have this development in mind the system has turned into an unintended direction the TARGET system was designed to guarantee a smooth processing of cross border payments between banks in the euro area it was not designed to provide long term credits to illiquid or even insolvent banks

21 TARGET balances a risk? TARGET balances reflect changes the composition of the monetary base in the Eurosystem excessive creation of central bank money in the periphery central bank money backed by collateral with a high probability of default collateral used for refinancing operations are typically domestic government bonds some argue that collateral is not important in a fiat money system not convertible to any other thing limits the borrowing capacity of banks (collateral as a proxy for the economic size of the bank)

22 TARGET balances a risk? TARGET balances reflect changes the composition of the monetary base in the Eurosystem long run risk for the credibility and acceptance of the currency if a lender of central bank money defaults, the refinancing credit is replaced with the collateral (government bond) if the government bond also looses its value (government default), the central bank has a write off it looses capital the monetary base is circulating without assets under the control of the CB if the central bank looses the control over the asset side, it looses the control over the monetary base fortunately, the US dollar and most other currencies are not better off

23 TARGET balances what to do? is there a natural end to this policy? at first sight sterilization by the Bundesbank would no longer be possible, if the volume of refinancing operations drops to zero however German banks can deposit excess liquidity at the Bundesbank

24 TARGET balances what to do? is there a natural end to this policy? liquidity provided 31 bn bn. = 69 bn. liquidity absorbed 57 bn bn. = 136 bn. German banks are net creditors vis à vis the Bundesbank

25 TARGET balances what to do? is there a natural end to this policy? this policy is unlimited, as long as banks can deposit whatever amount is in excess of actual demand deposit facility is unlimited, but very low interest rate (75 bp below minimum bid rate) term deposits limited to the volume of the SMP

26 TARGET balances what to do? stop providing unlimited liquidity by the Eurosystem (return to variable rate tenders) as long as periphery banks continue to be short of liquidity, they would absorb all the refinancing credits interest rate would significantly rise above the minimum bid rate banks in the core would abstain from participating at tender operations and exchange their central bank money balances on the interbank market danger for interest rate transmission since ECB only makes operations with GIPS banks + the amount of the public cross country loans to periphery countries would be limited, since the volume of refinancing operations would be limited

27 TARGET balances what to do? limit the build up of the balances adopt a mechanism that is applied in the US system the liabilities of a district Feds against another district Fed are booked in the Interdistrict Settlement Account (the equivalent to the TARGET account) these liabilities must be settled in April of each year settlement means that liabilities are redeemed with marketable securities bearing normal interest rates GIPS central banks would have to transfer assets to core central banks this would still be a capital import to the GIPS but under market conditions, and not at the favorable risk free minimum bid rate

28 TARGET balances to sum up TARGET credits are a solution to temporary balance of payments frictions they are no long run solution to finance unsustainable businesses this not the task of monetary policy solve the fundamental problems of banks (and governments) as fast as possible so that monetary policy can concentrate on its primary mandate