Misguided Target2 theory is not borne out by the facts

Tue, Apr 3, 2012, 01:00

SERIOUS MONEY: The German taxpayer is no more exposed to financial losses than if the Target2 claims within the Eurosystem resided on the balance sheet of the Central Bank of Ireland

CONSPIRACY THEORISTS typically sell their paranoid version of the world in tabloid newspapers, best-selling novels and blockbuster movies, but it is unusual for such narcissistic drivel to make its way into the “dismal science” of economics.

This is exactly what has happened over the past year as Prof Hans-Werner Sinn, a German economist and president of the Ifo Institute for Economic Research at University of Munich, sparked a heated debate over the nature of the surge in so-called Target2 claims within the Eurosystem – an argument that has left those financial journalists and investment commentators who fell for Sinn’s hype with egg on their faces.

Sinn has drawn attention to a particular item on the Bundesbank balance sheet – “Other claims within the Eurosystem (net)” – that has grown from €5 billion at the end of 2006 before the financial crisis began to almost €500 billion by the end of last year.

This observation – alongside a surge in the net liabilities of the central banks of the peripheral countries within the Eurosystem – has seen the economist arguing that “the euro zone payments system has been operating as a hidden bailout whereby the Bundesbank has been lending to the crisis-stricken euro zone members via the Target system . . .”

Sinn argues the increase in Target2 claims at the Bundesbank is perpetuating current account deficits in the periphery while crowding out credit to the German banking system, and exposes German taxpayers in the event of financial losses. His arguments have proved too seductive for some, but in reality the spin is misleading in some cases and just plain wrong in others.

It is important to outline what Target2 is. Target2 – or Trans-European Automated Real-Time Gross Settlement Express System – is a payment system used for the cross-border transfer of central bank money between euro zone central banks. Suppose an Irish bank wishes to send a payment to a German bank. Target2 reduces the Irish bank’s account at the Central Bank of Ireland, and generates a deposit in the German bank’s account at the Bundesbank.

The European Central Bank (ECB) acts as an intermediary in this process, whereby the increase in Bundesbank liabilities is offset by a claim on the ECB. Similarly, the ECB has a claim on the Central Bank of Ireland, which has a claim on the Irish bank.

Before the financial crisis, Target2 positions were close to balance, as the large and persistent current accounts deficits in the periphery were easily financed by private capital flows. Once turmoil erupted and concerns mounted over the solvency of periphery banking systems, banks in Portugal, Ireland, Greece and Spain were effectively shut out of the interbank lending markets.

The scale of the capital outflow vastly exceeded the current account deficits in the periphery, and threatened a systemic event should the banking systems collapse. The Eurosystem had to step in and provide unlimited funding to the periphery, which sparked the surge in Target2 imbalances.

These imbalances are a function of capital flight and not the current account positions in the periphery. The notion that current account imbalances are being perpetuated via the Target2 system is simply not borne out by the facts. The respective banking systems are engaged in a deleveraging process that has seen a sharp tightening of lending conditions, while the current account positions are improving across-the-board with Ireland even managing to return to surplus.

Sinn’s argument that this process is crowding out credit to the German banking system is also misguided. It is true that the use of the ECB’s refinancing operations by German banks has declined in the recent past, but they have certainly not been crowded out. The ECB is meeting the full amount of liquidity requested by banks, conditional upon sufficient eligible collateral. The German banks are not in need of liquidity – hardly surprising given they have benefited from flight of capital from the periphery.

The German taxpayer is no more exposed to financial losses than if the Target2 claims within the Eurosystem resided on the balance sheet of the Central Bank of Ireland. The counterparty to the claims of the Bundesbank is the ECB, and losses incurred by the monetary authority are pooled and shared between all national central banks in the Eurosystem according to their ECB capital share, or 27 per cent in the case of Germany.

Sinn’s arguments are misleading and dangerous, given his points have been bought by several financial journalists and investment commentators. The folly in his thinking can be best demonstrated by considering what might have occurred had this funding not been in place. The banking systems in the periphery would in all likelihood have collapsed and the strain on the single currency could well have proved unbearable.

The German economist is misguided, and those who see conspiracy theories for what they are will know better.